Tue, 03 Aug 2010
From: Reuters
By Sunanda Creagh
JAKARTA Aug 2 (Reuters) - Indonesia is attracting enormous emerging market investor interest, partly thanks to President Susilo Bambang Yudhoyono's market-friendly reforms.

That trajectory, however, is imperilled by vested interests who stand to lose out if measures aimed at increasing transparency and creating a level playing field succeed.

Reforms could propel the country to achieve an investment grade credit rating within a couple of years, putting it on a par with BRIC nations such as China and enabling more institutional investment in its bonds. [ID:nJAK135796]

Strong foreign buying in anticipation of sovereign ratings upgrades pushed down one-year bond yields ID1YT=RR to 5.9 percent in late July, from around 12 percent at the end of 2008. 15-year bond yields ID15YT=RR have dropped to a record low of 8.8 percent, from 12.2 percent at end-2008.

Stocks .JKSE surged 20 percent to a record in July, making Jakarta Asia's best performing major index, while the rupiah currency IDR= is up 4.6 percent, driven by capital inflows.

The sovereign credit default swap spread IDGV5YUSAC=R has tightened to around 150 basis points, from 195 bps at the end of last year, and from 640 bps at end-2008. But it remains higher than Thailand's 113 bps or Malaysia's 90 bps.

Following is a summary of key Indonesia risks to watch:

* GOVERNMENT EFFECTIVENESS IN DRIVING REFORM

When Yudhoyono was re-elected with a strengthened mandate in 2009, many Indonesians hoped the ex-general would use his second and final term to shore up his legacy as a progressive reformer.

His cabinet seemed to bode well with respected economist Boediono as vice president, technocrats Sri Mulyani Indrawati and Mari Pangestu in key economic posts and Kuntoro Mangskusubroto heading a new unit monitoring ministerial performance.

But the political old guard moved quickly to isolate the reformers, who had made many powerful enemies through their anti-corruption efforts. Golkar, led by tycoon and politician Aburizal Bakrie, spearheaded a highly politicised inquiry into the role Indrawati and Boediono played in a 2008 decision to bail out lender Bank Century. The inquiry dragged on for months and, despite turning up no evidence of wrongdoing by the pair, led Boediono to retreat from the spotlight while Indrawati quit to take up a new post at the World Bank.

Indrawati's resignation was seen by some as a victory for her political enemies. But Agus Martowardojo, who replaced her as finance minister, also has a track record of standing up to powerful interests and he was quick to reiterate his commitment to continue Indrawati's reforms.

Soon after Indrawati left, however, Yudhoyono gave Bakrie a new post as coalition manager, raising questions over his commitment to reform. [ID:nJAK299378]

Analysts say the Bank Century saga may have eroded the appetite for bold decision-making in the Yudhoyono government.

Some positive signs have emerged. Yudhoyono's nominee for the position of central bank governor, respected economist Darmin Nasution, was approved by parliament in July, a decision welcomed by economists. [ID:nJAK448474]

In March, Boediono announced a new team to oversee a revamp of the bureaucracy -- a positive sign for foreign investors -- but by July the team had little to show for its efforts. Mangkusubroto has introduced regular progress reports on ministers and their projects, but despite several ministers being awarded "fail" grades this year, no heads have rolled so far.

Overall, however, 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.

What to watch:

-- In late August, parliament is supposed to debate a new land acquisition bill that would set strict time limits on negotiations over land deemed as crucial to the public interest. Weak land acquisition rules have held up vital infrastructure development. Jakarta-based political analyst Kevin O'Rourke said Golkar was likely to support the bill because of Bakrie family business interests in toll-road development but proposals to cancel land ownership certificates may be opposed by Islamic and opposition parties.

-- Opponents of reform, including those within Yudhoyono's ruling coalition, will probably try to block other pro-investment policies such as changes to the tough labour laws and cuts in energy subsidies. [ID:nJAK427204]

-- Progress with tax cases, particularly those involving Bakrie's companies such as Bumi Resources. [ID:nJAK389318]

* CORRUPTION AND GOVERNANCE

Yudhoyono was elected on promises to tackle graft but by early in his second term, the Corruption Eradication Commission (KPK) was under attack, with two of its leaders accused of abusing their power. They were vindicated when wiretaps played in court proved the pair were being framed by senior law enforcement officers working with corrupt businessmen, but many Indonesians felt Yudhoyono was slow to defend his top graft-busters.

In July, the office of an investigative magazine that had published a report on alleged police graft was firebombed. An activist at Indonesian Corruption Watch involved in uncovering evidence for the magazine report was brutally beaten, days after reporting alleged police corruption to the KPK. [ID:nJAK228890]

However, corruption investigations and convictions have continued, focusing mainly on mid-level officials. One mid-ranking tax officer was recently jailed for corruption and another is the subject of a court case over alleged bribery. Under Mangkusubroto, 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. However, the legal reform task force has gone quiet in recent months.

What to watch:

-- Who heads the KPK next. A new chairman will be chosen soon to replace Antasari Azhar, who was jailed for murder. With the KPK still under attack from vested interests, it's important the job goes to someone with impeccable credentials. [ID:nJAK149966]

-- Effectiveness of the 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. 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 but helping to contain imported inflation.

The rally has continued for this year too, prompting the central bank to intervene to stem the currency's gains as it broke through 9,000 per dollar in late July.

Such capital flows are closely watched by the authorities. Memories are still raw of the 1998 Asian crisis, which was widely blamed in Indonesia on foreign "hot money" being yanked from the country. In June, Bank Indonesia announced a range of new controls aimed at keeping foreign money invested longer in Indonesia, including a minimum one-month holding period for its SBIs and new 9-month and 12-month SBIs that will be made available later this year. [ID:nJAK275824]

The soft capital controls are leading foreign investors to shift into three-month paper and longer-dated government bonds, with net foreign ownership of government debt hitting a record high in July. [ID:nJAK197199]

What to watch:

-- The currency's strength, data on bond holdings, and the government's efforts to make its finances more stable by attracting long-term direct investment.

-- If the central bank fears hot money is destabilising, controls may be tightened. Draconian measures that send investors rushing for 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 the potential for capital controls. [ID:nHKG263506]

* SECURITY

Suicide bombings at two luxury hotels in Jakarta last July were the first major 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.

Earlier this year, police discovered a new network of armed militants operating a secret training base in Aceh in Sumatra province. The group was plotting to assassinate Yudhoyono and government officials at an independence day celebration, and wanted to create an Islamic state, police said. [ID:nJAK214087]

In late June, police captured preacher Abdullah Sonata on suspicion of involvement in the Aceh group. [ID:nJAK59920]

Sonata had been jailed in the past but released early for good behaviour. His return to militancy raises questions about the effectiveness of efforts to rehabilitate captured militants and prevent recruitment in jails. Police also uncovered a plan to attack a European embassy and a police ceremony in Jakarta. [ID:nSGE65O0E8]

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 limited and brief.



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