Time for a reality check in Indonesia

There are signs that Indonesia’s ineluctable promotion into the premier league of emerging economies could be derailed. A sudden shift of the current account into deficit, an embrace of capital inflows and a reliance on offshore dollar funding have prompted at least one analyst to warn that the country is increasingly vulnerable to systemic shocks.

“Indeed, while top-line macro data appears strong, underneath the economy has begun to experience the same destabilising financial engineering that preceded the 1998 financial crisis,” wrote Sean Darby, chief global equity strategist at Jefferies in a report on April 19.

The current account moved into deficit during the first quarter of 2012, which, as Darby pointed out, “has always been an important turning point for emerging market investors”. Export volumes have declined, partly due to a strong rupiah, and most worrying, there has been a significant deterioration in the income position, largely caused by Indonesian companies remitting interest payments to foreign investors.

“A similar scenario occurred in 1996-97 in the lead-up to the 1998 Asian financial crisis,” said Darby.

His warnings are cautiously contrarian, and Darby concedes that his bearish call is “early”, but argues that it is necessary when an “overcrowded” carry trade that has pushed the Indonesian equity market to its previous highs following the 2008 credit crisis, “appears to be immune ... to bad news”. The equity market rose 6.4% in US dollar terms during 2011, and local government bond yields have fallen from more than 10% to about 6% during the past couple of years.

But Darby reminded investors that Indonesian market prices also suffered a “sharp whiplash” during 2008 as financial contagion reversed the carry trade, forcing fund managers to sell shares and currency at the same time.

The good news has already been reflected in upgrades to investment-grade status by the rating agencies, Fitch (in December 2011) and Moody’s (in January 2012).

Annual GDP growth is expected to be around 6.5% during the next two years — although below the official target of 7% to 8% — and the economy is predominantly driven by domestic consumption rather than exports, providing a buffer against a worsening of conditions in Europe or the US. The country’s external debt has fallen from 140% of GDP in 2001 to 30% today, and foreign exchange reserves exceed $110 billion.

And beyond these numbers, despite persistent problems about governance, corruption and physical infrastructure, Indonesia has, Darby concedes, “just about everything that an investor could wish for: it’s rich in commodities, has excellent [youthful] demographics and a healthy banking system”.

But since 2008, inflationary pressures have led to higher domestic interest rates than in developed countries, and these have attracted overseas flows into the banking system and domestic bonds. More than 30% of government bonds are held by foreigners.

Although some of that excess liquidity has been sterilised by the Bank of Indonesia, exchange rate appreciation has absorbed the rest — worsening the terms of trade.

In addition, Indonesian companies have taken advantage of lower offshore interest rates and strong investor demand in the international bond markets. Although this makes sense, there is a danger that they may be caught out by currency mismatches between revenues and debt costs if the rupiah were to weaken.

Darby is clearly not afraid of an imminent crisis, but his reminder that progress is neither inevitable nor smooth is timely.