T

he equity market’s recent advance is pricing in expectations that Indonesia will achieve investment grade over the next 12 months in our view. This is rightly so given that the country’s credit default swap (CDS) at less than 150 basis points is now in line with many investment grade countries.

In fact, the risk for the markets would be if the investment grade status does not materialize for Indonesia as expected next year.

To recap, Fitch in January raised Indonesia’s long-term foreign debt rating to BB+ and assigned a stable outlook. This is followed by S&P having upgraded Indonesia to BB in March, but retaining a positive outlook. Meanwhile, Moody’s have kept its debt rating on Indonesia at Ba2 since September 2009, but decided to shift to a positive outlook in July.

In mid July, Japan’s credit rating agency (JCR) moved ahead, beating the others in awarding Indonesia its investment grade. Going forward, however, we expect at least one of the big three rating agencies will follow this lead. We discuss below issues which could accelerate the process towards the country’s investment grade, but could at the same time serve as impediments.

Political climate. This should remain cool in the next couple of years in our view as political tension with Golkar and other House members have diminished following the departure of finance minister Sri Mulyani. However, this political calm could also mean that corporate governance could be taking a back seat going forward. There is a need by opposition and the media to ensure that implementation of reforms and the fight against corruption will remain on course.

National security. With per capita incomes on the rise, threats in the forms of riots and protests are fading. The national police has made progress in terms of arresting alleged terrorists. This suggests that attacks by extremists or bombings should be increasingly isolated events in our view. However, the police must not rest on their laurels, as the fight against terrorism requires constant vigilance.

Higher GDP growth. GDP growth has averaged just under 6 percent per annum from 2005 to 2009 with the government’s target of achieving average 6-7 percent growth by 2014 appears achievable. This will be propelled by domestic demand, particularly as consumer debt levels are low while the banks are well capitalized. Having said that, it is important that banks remain cautious. Failure to do so could mean rapidly rising non-performing loans (NPLs).

Greater investment. In terms of investment, we feel that the country is moving in the right direction with investment as a percentage of GDP having reached 23 percent, favorable when compared to the 19 percent average for countries rated by Fitch as BB and the 22 percent average for those that are BBB rated. Nevertheless, Indonesia admittedly continues to score poorly relative to the rest of Asia in competitiveness surveys. The problem areas include but are not limited to insufficient infrastructure, cumbersome bureaucracy and contract enforcements/ legal certainties. These need to be continually addressed by the government.

Well-managed budget. There is a constitutional cap in place limiting the country’s fiscal shortfall to no more than 3 percent of GDP each year. This has paved the way for Indonesia’s debt ratios to be in investment grade territory. Indonesia’s budget deficit has averaged 0.98 percent of GDP since 2005, relatively in line with the average for countries rated BBB by Fitch. On the flip side, government debt to GDP at 26 percent is substantially lower than the 35 percent BBB average.

Buoyant foreign exchange (FX) reserves. Indonesia’s foreign exchange reserves as of August this year have reached US$80.9billion, the highest ever in history. This ranks Indonesia as the No. 21 country in the world with the highest amount of FX reserves, and should score positively with rating agencies. Nevertheless, foreign portfolio investment has surged and will stay volatile in our view. However, wild swings in the rupiah should be avoided in future, partly helped by curbs recently introduced to constrain inflows into short term debt instruments (i.e. investments in one-month SBI’s must be kept for a minimum of one month).

In sum, expectations for Indonesia to achieve investment grade in the next 12 months is high. While investment grade status would broaden the range of investors able to hold Indonesian assets, failure would sour investment sentiment into the country. Thus, it is imperative that the authorities maintain stability as discussed above, wiping out any lingering vulnerability that could deny Indonesia its investment grade status.

The writer is senior vice president and head of research at PT Bahana Securities.