O

ver the past few months, there has been a sudden surge in interest in Indonesia among the international investor community. A US investment bank said the BRIC economies (Brazil, Russia, India and China), which had been fueling global growth for several years before the global financial crisis hit the global economy in the second half of 2008, should now include Indonesia.

Another securities house has ingeniously invented the term "Chindonesia": China, India and Indonesia, as Asia's economic bulwarks. Even the World Bank has said that Indonesia could emerge as the "winner" of the current global economic crisis. Indonesia is suddenly hot, back on the radar of global investors who, during the Asian financial crisis of 1997-1998, abandoned the country en masse.

The investors' vote of confidence came, of course, with their money. Since the start of 2009, Indonesia's stock exchange (ISE) index in US dollar terms has risen by around 95 percent (at one stage more than doubled), making the bourse the world's second-best and Asia's best performer.

There are two very big reasons why global investors have suddenly fallen in love with Indonesia - bearing in mind that investors can have love-hate relations with the countries they invest in.

The first is political stability. In 1998 Indonesia was the "sick man of Asia", where political instability and widespread riots not only brought down strongman president Soeharto (who had ruled the country for 32 years with an iron fist), but also threatened the very integrity of Indonesia.

Lieutenant general Susilo Bambang Yudhoyono, at the time the military's chief political officer, who would later become president, even wrote in a daily newspaper about the threat of "Balkanization": the possibility Indonesia could break up into various island states.

But fortunately Indonesia did not blow up. The country embraced Western-style democracy in 1999 with its first truly free general elections, and has since become the world's third-largest democracy, after the US and India. Amazingly, all elections over the last 10 years (whether at the presidential, gubernatorial or municipal level) have been peaceful. With all its shortcomings, democracy has become a political shock absorber, creating the stability that investors need as a necessary prerequisite for solid growth.

Mere political stability is, certainly, not enough. Just like any ambitious corporation, Indonesia needs a government that has vision, mission and the discipline to implement politically painful reforms.

The re-election of President Yudhoyono for a second and final five-year term (given the constitutional limits) means the continuation of investor-friendly changes (from the much-vaunted anticorruption drive to tax reforms).

Moreover, with the rise of former Bank Indonesia governor Boediono to the vice presidency, the investor and business communities now have a figure they know and respect. As vice president, Boediono is likely to coordinate the next economic team.

The second reason is economic potential. In the first half of 2009, Indonesia's economic or GDP growth was 4.2 percent on a year-to-year basis - the third-highest in the G20 after China and India (Indonesia is already the world's 16th-biggest economy). While we expect Indonesia's GDP growth to fall from 6.1 percent in 2008 to 4 percent in 2009, Indonesia's performance will still be impressive, considering that the World Bank expects the world economy to contract by 1.4 percent.

We expect Indonesia's GDP growth to recover to 5 percent in 2010, 6 percent in 2011 and potentially to 7 percent in 2012.

To assess the long-run potential of the Indonesian economy, we have calculated the compound annual growth rates of the G20 countries between 2000 and 2008. Assuming that Indonesia's growth will rise to potential by 2012, the size of Indonesia's economy will surpass, for instance, South Korea's in 2016, Japan's in 2024, the UK's in 2031 and Germany's in 2040. In short, Indonesia could merit inclusion in the G7 by 2040.

Even if Indonesia's economy only grows by the average annual rate seen during 2000-2008, Indonesia is still likely to be in the G7 by 2045 (see Standard Chartered's special report, Indonesia: Asia's emerging powerhouse *Sept. 2, 2009*).

The foundation for Indonesia's future economic growth rests on three pillars.

The first is domestic consumption. In 2008, 60 percent of the economy was powered by household consumption, 10 percent by government spending, 28 percent by real investment and less than 2 percent by net exports (exports minus imports). This means, like China and India, Indonesia's economy by and large is domestically driven (by its large population) and is less dependent on exports.

The second pillar is infrastructure development. Since the Asian financial crisis, the priority of post-Soeharto governments has been economic stabilization, not infrastructure development. However, to ensure that economic growth can rise to its potential, more toll roads, power plants and improved harbors and airports are needed, not only to create employment (and stimulate consumer spending), but also to attract private investment.

The third pillar is commodities. While Indonesia is a net importer of oil, it is a large net exporter of energy (gas, coal and palm oil), as well as other basic commodities such as rubber and tin. Indonesia is already the world's biggest palm oil producer. Almost 40 percent of Indonesia's exports are commodities, whose prices are expected to rise as the global economy recovers and the global population grows.

Of course there are also challenges that could derail such an optimistic outlook. In the short run, the biggest challenge is financial in nature. Indonesia's foreign exchange (FX) reserves are small compared to those of other Asian countries and relative to its external liabilities.

Despite the availability of bilateral FX swap agreements with China, Japan and Australia (which could help increase FX reserves temporarily), Indonesia remains exposed to potential capital flight, which could rapidly deplete its FX reserves and sharply weaken the Indonesian rupiah (IDR).

Although we believe the worst of the global financial crisis is over (which reduces the likelihood of sharp rupiah weakness in the near future), it is essential that both the government and BI exercise policies to encourage foreign direct investment - the most stable source of FX reserves. Foreign investment in domestic financial markets (BI certificates or SBIs, IDR government bonds, and equities) - i.e. foreign "hot money" - is a potential source of balance-of-payments instability in the case of capital flight. As of August 2009, foreign investment in Indonesia's stock market alone was US$113 billion, or around 65 percent of the market's capitalization.

While most of this investment is strategic and long-term in nature, the amount still exceeds the country's FX reserves. Furthermore, foreigners held $9.2 billion of IDR government bonds (16.5 percent of the total) and almost $1.4 billion of SBIs, a more liquid investment.

In the long run, the biggest challenge is the need to have equitable growth. While GDP growth has helped reduce poverty and unemployment, income inequality has widened, as shown by the country's rising "Gini coefficient of inequality". The fruits of economic growth are being enjoyed disproportionately by the middle- and upper-income groups.

The government has implemented policies to narrow the gap, such as a progressive tax regime and cash handouts to the poor. However, about 42 percent of the labor force is employed in the slow-growing agricultural sector, which generates only 14 percent of GDP.