The start of 2010 has been a joyous moment for the markets. The Indonesia Composite Index has surpassed 2650 or up by five percent since end-2009.

Meanwhile yields on the 5-year government bond have fallen by 0.7 percentage points, which also means a five percent gain in price.

January is usually a time when fund managers across the world reallocate funds in their portfolios, after having gone on year-end holidays.

At the same time Indonesia was coming up with “favorable” news: planned increases in electricity tariffs were delayed and fuel price  increases were apparently ruled out, thereby suppressing inflationary expectations for now. Earlier projections of imminent rate increases were also toned down accordingly.

So far the past two weeks have exhibited symptoms of a bull market. Viewed from another perspective, the delay in electricity tariff  increases doesn’t seem like a step in the right direction. It is a setback in needed reforms caused by rising political risks. Yet when global liquidity is flush, even black can appear to be white.

This current episode of market optimism will have a number of implications. As for the many of us who had our feet dragged down in 2008, the time may be coming to recoup losses. The government should enjoy some slack as well, as the budget deficit can be financed at substantially lower yields.

Emerging market sovereign spreads over US treasury yields are currently compressed, hovering close to their pre-crisis levels. Just this week, the issuance of 10-year US dollar debt by the government cost an interest rate of six percent per annum.

Of course this is more expensive compared to the Philippine government bond sold at 5.76 percent just a week earlier, but it’s still much lower than the double digit rates demanded early last year.

However bull-markets do not bring all good news. There are also challenges ahead for the economy.

In 2009, the strong appreciation of the rupiah was cheered because it was a step towards normalization—following the fall of the local currency to over 11,000 against the dollar in the previous year. The rupiah strengthened naturally as imports dropped faster than exports and lead to a widening of the trade surplus against the rest of the world.

In contrast, the rapid appreciation of the rupiah towards 9,100 in the beginning of this year may have entered a new phase, one which should be closely monitored. Although Indonesia’s trade surplus remains intact, the appreciation increasingly appears to be driven by portfolio capital inflows.

Indeed on a trade weighted basis, the rupiah is still not as strong as it was before the 2008 crisis.

However after adjusting for differences in the rate of inflation among our trading partners (commonly known as real effective exchange rate analysis in economic jargon), the local currency’s strength does appear to be close to breaking pre-crisis levels.

This is of course unfavorable news for the economy, as Indonesia’s exports could become less competitive. Moreover with the implementation of the ASEAN — China Free Trade Agreement on Jan. 1, China-produced goods could become even cheaper and further drive up imports.

Thus for the monetary authorities, it looks like the task of maintaining currency stability has become ever more important this year. The global investment community’s optimism on Indonesia
should not be allowed to adversely affect the recovery of real sector economic activity.

Hence after stirring up controversy surrounding possible restrictions on foreign purchases of Central Bank Certificates (SBIs) late last year, BI could see the pressure to act further intensifying going forward. Changes may be needed to prevent BI’s monetary instrument from continually being hijacked as a vehicle to take positions on the currency.

After all in the first week of 2010, the foreign fund flows which helped drive up the rupiah were said to be stronger into SBIs compared to bonds. Year 2010 is indeed a unique year for Indonesia.

Contrary to 2009, the key risk in store is not of a full-fledged financial crisis or economic meltdown, but of a recovery to a path of mediocre growth—with reforms seeing little progress. If reality indeed falls short of expectations, the markets should brace for a correction. And maybe then, black will no longer be seen as white.

In order to be sustainable, optimism in the markets must be coupled by real sector progress. Let’s not forget that the country is still in urgent need of green-field direct investments in non-resource based sectors, as well as a revitalization of the manufacturing sector.

Hopefully the long-promised economic, legal and bureaucracy reforms aren’t further shifted downward in the government’s list of priorities, although tensions continue to rise as the Bank Century bail-out inquiry unfolds.


The writer is currently an economist at Bank Danamon Indonesia. The views expressed herein are
his personal.

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