Indonesia has been constantly grouped with the weakest EM countries. Despite its numerous potential fragilities, the country has held up relatively well from a fundamental perspective – perhaps more than the dramatic moves FX and equity markets would suggest. While we are not turning outright bullish in Indonesia, we note that many of the fundamental concerns about the country may have been overblown. Here we look at the recent pattern of foreign investor flows into bond and equity markets, as well as to the country’s external sectors.
It has been a difficult year for Indonesian equity markets, and this has been reflected in the behaviour of foreign capital flows. The Jakarta Composite has lost 21% year to date, and 33% when the currency loss is taking into account, making it by far the worst performer in the region. It is therefore no surprise that capital outflows from the equity markets have been strong. If the trend continues, this will be the first year in the last five that the country experiences net equity outflows (the only other year was 2013). It’s worth noting that our EM Equity model has Indonesia as an underperformer, and so the poor equity performance is not a big surprise to us.
However, it has been a different story in the fixed income markets. Foreign inflows have held up relatively well. So far, this year has seen the second greatest net inflows into the fixed income markets over the last five years (surpassed only by 2014).
In addition, there are no red flags from the much watched data series on foreign holdings of domestic debt. Foreign holdings have trended lower since its 2015 peak of just over 40% of total, but at 38%, it’s about the same level as the start of the year.
It’s worth noting, however, that the spread between 10-year yields in Indonesia and the US – which had been relatively stable between 500-600 bp since mid-2013 – began to widen over the last few months. This suggests an increase in risk premium, probably due to some combination of risk aversion, especially towards EM, and firming of the view that the Indonesian central bank will not hike rates, despite elevated inflation. Upside risks to inflation include pass though from the weaker rupiah along with the impact of El Nino on food prices. While we see this increase in premium as justified, especially since Indonesia fixed income markets become notoriously illiquid during times of stress, it’s unlikely to be permanent. Moreover, it’s important to note that the rise in yields did not seem to have a significant impact on foreign investor in the fixed income side.
On the fundamental side, there has been some good news on Indonesia’s external accounts. As a percent of GDP, the current account deficit has narrowed from -3.6% in 2013 to around -2.5% now. The trade balance has been improving, but this has been largely due to weaker imports and the weaker currency. Still, the improvement in the current account has more than made up for the gradual decline in FDI, and should not be overlooked. Moreover, Indonesia’s FX reserves have declined steadily over the last few months, but are not at a concerning rate, in our view. Smoothing FX operations has brought FX reserves from a $116 bln in February, to $105 bln at the end of Augusts.
In terms of competitiveness, we note that the Indonesian rupiah has been around the middle of the pack when it comes to real exchange rate performance. Over the last 12months, the rupiah has appreciated 1.7% in REER terms, according to the the BIS’ calculations. This compares with a 9.6% appreciation of the CNY and a depreciation of 11% of the MYR. The reason for the IDR’s performance come down to a relatively high inflation rate, which offset the currency’s nominal depreciation against Indonesia’s three top trading patners: China (-15%), Singapore (-6%) and Japan (-2%).
With EM likely to remain under pressure, we expect USD/IDR to continue making new cycle highs. The pair is about to test the 15000 area, and is trading at levels not seen since 1998. Indeed, charts point to test of the June 1998 high near 17000.
Lastly, we note that Jokowi’s government is trying to take back the initiative with a cabinet reshuffle and the announcement of a series of reforms. This batch will focus on deregulation, reducing red tape, and simplifying the procedure for infrastructure projects, but it also contains a low-cost housing program. As such, they are certainly positive, but more of a medium- to long-term story. The main near-term growth driver will likely be determined by the implementation of this year’s fiscal policy, which some reports suggest has started off very slow.