The Year of Living Dangerously


Indonesian markets open tomorrow for the first time since June 8, and face a sobering new reality.  Bank Indonesia has already hiked rates twice pre-emptively, and may be forced to do so again.  However, Indonesia can look forward to continued political stability. 


President Joko Widodo (Jokowi) is in the last year of his first 5-year term.  He remains popular, regularly leading all polls ahead of the next election.  The economy has fallen short of his pledge of 7% growth, but Jokowi’s popularity has not suffered much, it seems.  He cut costly fuel subsidies and opened up the country to foreign investment.

Elections will be held in April 2019.  The presidential and parliamentary vote will be held simultaneously for the first time.  A presidential candidate requires the backing of parties holding at least 20% of the seats in parliament or 25% of that vote.

Former General Prabowo Subianto will likely see a rematch with Jokowi.  In the 2014 election, Jokowi beat Prabowo 53-47%.  Recall that Prabowo disputed the 2014 election and withdrew before the count was completed.  Recent polls suggest Jokowi will come out on top again to serve a second and final 5-year term, and this is our base case.

Note Prabowo has a bit of a checkered history.  He was former President Suharto’s son-in-law before a divorce from his second daughter in 1998.  Prabowo was later discharged from the military and banned from entering the US due to allegations of human right violations during Suharto’s reign.  Before the 2014 election, Prabowo ran and lost in 2009 as the running mate of Megawati Sukarnoputri.

Corruption remains one of the country’s biggest challenges.  Indonesia scores low in the World Bank’s Ease of Doing Business rankings (72 out of 190).  The worst components are starting a business and enforcing contracts, while the best are getting electricity and resolving insolvency.  It does slightly worse in Transparency International’s Corruption Perceptions Index (96 out of 180 and tied with Brazil, Colombia, Panama, Peru, Thailand, and Zambia).      


After its loss in World War II ended Japan’s occupation of Indonesia, nationalists immediately declared independence from the Dutch.  Returning Dutch forces, aided by the UK, clashed with these nationalists, who were led by Sukarno and many others.  After several years of fighting, the Netherlands formally recognized independence for Indonesia in 1949, with Sukarno becoming the first president.  Sukarno was named president-for-life in 1963.

During his rule, Sukarno became increasingly autocratic.  Furthermore, he veered to the left in the 1960s, supporting the Indonesian Communist Party (PKI) and accepting aid from the Soviet Union and China.  As the PKI became the strongest party in Indonesia, tensions with the military inevitably grew even as the economy was deteriorating.  This tumultuous period provided the backdrop for the well-known and well-regarded Peter Weir film “The Year of Living Dangerously.”

A failed coup attempt by members of the armed forces resulted in the assassination of six Army generals on October 1, 1965.  The coup attempt was blamed on the PKI, and violent anti-Communist purges soon shook the country.  Some have theorized that the coup was staged by Suharto as an excuse to seize power.  Sukarno attempted to hang on to power but was stripped of his president-for-life title in March 1967.   Suharto took over and so began the “New Order.”

Suharto ruled Indonesia from 1968-1998 in a period of one-party rule that held until the Asian Crisis.  Thailand was the first to come under pressure, and the baht’s peg was broken on July 2, 1997.  Malaysia came under pressure next and responded with FX intervention and rate hikes, though the ringgit was not pegged at that time.  Next to devalue was the Philippines on July 11.

Indonesia also came under pressure and responded by widening the rupiah’s trading band on July 11.  Indonesia then abandoned the trading band and floated the rupiah on August 14.  However, it did not request an IMF program until October 8.  A $10.1 bln standby agreement was quickly reached and approved on November 5.  The World Bank and ADB kicked in another $8 bln, making this one of the largest programs of that time.

Many would argue that Indonesia entered the Asian Crisis with solid fundamentals.  The current account deficit was half Thailand’s, while the budget was in balance.  It has been reported that while Indonesian officials were concerned about contagion from Thailand, IMF officials were initially much more sanguine.  However, the currency crisis morphed into a banking crisis.

With the economy already reeling from an IMF program that was a heavy reliance on austerity, Indonesia certainly suffered.  It is widely accepted that of the three countries that accepted IMF aid, Indonesia experienced the worst of the crisis.  GDP contracted -13% in 1998 vs. -5.5% for Korea and -10.4% for Thailand.  Indonesia also experienced little recovery in 1999 while the other two bounced back more quickly.

The deepening crisis led to the violent riots in May 1998, caused by food shortages and rising unemployment.  Ultimately, the economic crisis cost President Suharto his job as he lost the support of the populace and the armed forces.  He was forced to resign in May 1998 and was replaced by his Vice President Habibie, who served as interim President until the 1999 election.


The economy is picking up modestly.  GDP growth is forecast by the IMF at 5.3% in 2018 and 5.5% in 2019 vs. 5.1% in 2017.  GDP rose only 5.1% y/y in Q1, down from 5.2% peak in Q4.  As such, we see some downside risks to the growth forecasts.  Surprisingly, sluggish growth has not hurt Jokowi’s popularity in any significant manner.

Price pressures remain low but likely to rise.  CPI rose 3.2% y/y in May, near the lows of the cycle and at the bottom of the 3-5% target range.  In and of itself, the inflation trend suggests little urgency to tighten policy.  Bank Indonesia last cut rates in September, and CPI inflation has fallen since then.  WPI inflation has picked up to 3.2% y/y, the highest since May 2017.

Bank Indonesia started a tightening cycle with a 25 bp hike to 4.5% in May.  New Governor Perry Warjiyo came in and continued the cycle with a 25 bp hike intra-meeting later that month.  The next scheduled policy meeting is June 28, and another 25 bp hike seems likely.  Warjiyo stressed how important it is to act preemptively, and so the rate hikes are clearly meant to support the rupiah and boost confidence.

The fiscal outlook bears watching.  The budget deficit was an estimated -2.7% of GDP in 2017.  The OECD expects this gap to narrow to -2.3% in 2018 and -2.2% in 2019.  However, with an election due next year, we expect the fiscal spigots will be opened and so we see upside risks to these deficit forecasts.

The external accounts are in decent shape.  The current account deficit was -1.7% of GDP in 2017, and the IMF expects the deficit to widen slightly to -1.9% in both 2018 and 2019.  However, export growth has been slowing noticeably this year, leading the trade surplus to narrow.  This suggests some upside risks to the deficit forecasts.

Foreign reserves have fallen in recent months and vulnerabilities are rising.  Reserves peaked at $132 bln in January but have since fallen every month to $123 bln in May.  They cover 6 months of imports and are equal to around twice the stock of short-term external debt.  Whilst these are not terrible metrics compared to others in EM, the budget deficit and large negative Net International Investment Position (-34% of GDP) suggest caution is warranted.

Foreign ownership of Indonesian government bonds peaked at 41% in January before falling to a still-high 38% in May.  In order to lessen its dependence on foreign funds, the government is planning a second online retail offer to locals this year, according to Luky Alfirman, director-general for budget financing and risk management at the Finance Ministry.  However, Indonesia remains vulnerable to shifts in hot money flows from abroad.


The rupiah is performing OK after a subpar 2017.  In 2017, IDR was -1% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), TRY (-7%), and BRL (-2%).  So far in 2018, IDR is -2.5% and is near the middle of the EM pack.  Compare this to the best performers COP (+2%), MYR (+1%), and CNY (+0.3%) as well as the worst performers ARS (-33%), TRY (-20%), and BRL (-11.5%).  Our EM FX model shows the rupiah to have NEUTRAL fundamentals, and so we expect this market-neutral performance to continue.

In late May, USD/IDR traded at its highest level since October 2015.  Bank Indonesia’s aggressive policy response helped the rupiah recover, but it remains vulnerable.  The MSCI EM FX index has fallen about 2% since June 8, when IDR last traded.  Interpolating from that level, we would expect USD/IDR to gap higher to around 14211, which is just shy of the May high near 14213.  Clean break of that level would set up a test of the October 2015 high near 14828.

Indonesian equities continue to underperform.  In 2017, MSCI Indonesia was up 22.5% vs. 34% for MSCI EM.  So far this year, MSCI Indonesia is -12% YTD and compares to -6% YTD for MSCI EM.  Our EM Equity Allocation Model has Indonesia at UNDERWEIGHT, and so we expect Indonesian equities to continue underperforming.

Indonesian bonds are underperforming.  The yield on 10-year local currency government bonds is +99 bp YTD.  This is behind only the worst EM performers Turkey (+478 bp), Brazil (+178 bp), Hungary (+147 bp), and the Philippines (+124 bp).  With the weak rupiah likely to feed into higher inflation and the central bank forced to continue hiking rates, we think Indonesian bonds will continue to underperform.

Our own sovereign ratings model shows Indonesia’s implied rating steady at BBB+/Baa1/BBB+ after rising a notch last quarter.  Actual ratings of BBB-/Baa2/BBB are still enjoying some upgrade potential.