Can Indonesia be Asia’s star bourse for a third straight year?

Indonesia’s stock market in 2010 was the star performer among the 10 countries in the MSCI Asia ex-Japan Index for a second straight year.1 So far, however, 2011 hasn’t been as stellar.

The good news for stock investors first. The Jakarta Composite index rallied 46% last year, after soaring 87% in 2009, as investors chased stocks benefiting from an economy rejuvenated by reform. Since he was elected to power in 2004 (and re-elected in 2009), President Susilo Bambang Yudhoyono has implemented financial, tax, customs and capital market reforms and introduced stimulus measures to shepherd southeast Asia’s largest economy through the global recession.

The result was that Indonesia’s economy grew at an average annual pace of 5.5% in the past three years, a fair achievement during a global recession. Investors thought the world’s fourth most-populous country of 240 million people could maintain that growth rate in coming years.

But that thinking didn’t last too long into 2011. On January 3, the Central Bureau of Statistics said consumer prices in Indonesia jumped 6.96% in 2010. Stocks fell on a view that the central Bank Indonesia will need to raise the benchmark reference rate by 100 basis points over 2011, to slow the economy and lower consumer inflation to under 6%.

The slide in stock prices was exacerbated, almost perversely, on January 5 when Bank Indonesia at its monthly policy-setting meeting left the reference rate unchanged at 6.5% for a 17th consecutive month. Investors fretted that a larger overall rate increase would be needed in the long run if the central bank didn’t attack inflationary pressures quickly. Over the three trading days from January 7 to January 11, the market plunged more than 8%. For January, the index dropped 7.9%, a decline beaten only by India’s slump of 10.6%.

Stocks did better over February because the Bank Indonesia finally acted against inflation, raising the reference rate by a quarter point to 6.75% on February 4. The Jakarta Composite Index gained 1.8% in February, to be Asia’s third-best performer for the month, but still ended the month as Asia’s third-worst performer so far in 2011.

The main action Indonesian authorities took last year to curb inflation was to order banks to set aside more reserves. The central bank kept interest rates on hold because core inflation, at just 4.3% in 2010, is under its 5% target. The bank has been cautious about raising rates because it is concerned that higher rates will encourage speculative foreign inflows and expects the jump in food prices that is fanning inflation to be only temporary.

Heavy rains in recent months have disrupted food production across the archipelago and boosted the price of staples. Rice is reported to have risen about 10% recently, while the country’s favourite spice of chilli pepper has nearly trebled in price. Food comprises about 20% of the basket of goods used to calculate inflation in Indonesia.

An upbeat future

But hey – even if inflation and interest rates rise this year, optimism abounds about a country that fewer than 15 years ago almost collapsed politically and economically – even if it still has many challenges such as a lack of infrastructure and an abundance of red tape.

Politically the Muslim country is stable. After overthrowing 31 years of the Suharto dictatorship in 1998, the country has turned itself into a secular democracy and controlled extremist voices. So successful has this transformation been that the country is touted, along with Turkey, as a model for Muslim countries in North Africa that have overthrown autocratic regimes in recent weeks.

It’s not just investors who are upbeat about an economy that is posting a current-account surplus of around 1% of GDP, where the government’s finances are under control, and where inflation, while troublesome, is well below the double digits recorded as recently as 2002.

In December, the government articulated an economic vision for 2025 that sees Indonesia as one of the 10 largest economies in the world with a per capita GDP of US$12,800 to US$16,160, from about US$4,000 now. The IMF expects the economy to grow between 6% and 7% in the coming four years.

On February 25, Fitch Ratings raised its outlook on the country’s sovereign rating, to imply that Indonesia’s debt is soon to be classed as investment grade. Fitch at the moment rates Indonesian debt BB+, its highest non-investment-grade, or junk, rating.

In December, Moody’s Investors Service upgraded Indonesia’s sovereign rating one notch to Ba1, its highest non-investment-grade rating, because of the government’s improving debt position and the country’s build-up of foreign reserves, which stood at US$96.2 billion on December 31.

“The economic policy framework remains increasingly well positioned to deal with evolving macroeconomic challenges and potential shocks,” Moody’s said in a release, foreshadowing the upgrade.2

Including, stock investors take note, the challenge of inflation.

Jakarta Composite versus MSCI Asia ex-Japan Index since start of 2009