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t has been more than 12 years since the 1998 Asian financial crisis, and Indonesia still has not managed to regain its investment grade status from rating agencies like Fitch, S&P’s and Moody’s.

In the last few years, Indonesia has been blessed with relatively stable political condition, which enabled both portfolio and foreign direct investments to come in. This coupled with strong international commodities prices accelerated Indonesia’s economic growth, resulting in flushed foreign exchange reserves, which reached the
highest ever at US$106 billion in March 2011.

The above trends translate to the maturation of Indonesia’s institutions and policy framework, as evidenced also by the easing of the country’s fiscal and external debt burdens stemming from the government’s track record of pragmatic fiscal and debt management policies.

The strong fundamental improvements that we have seen in Indonesia in recent years is the reason why, Fitch is looking to upgrade Indonesia’s long-term foreign currency sovereign debt to investment grade sometime in the next 12-18 months. This move, when it materializes, will reinforce the market’s perception that Indonesia has been on the right track.

More importantly, the upgrade, reflecting a safer investment destination, would make it possible for a wider universe of international investors, including massive US pension funds, to begin investing into the Indonesian stock market.

However, the real plus for Indonesia will come when a second rating agency also upgrades Indonesia’s rating as large US fixed-income investors, including pension funds and other institutional investors use the Lehman Aggregate Bond Index as their benchmark, which requires two investment-grade ratings in order for a bond to be included in the index. Worth noting is that once a rating agency upgrades, at least one would tend to follow within a year.

While the upgrade is expected to spark positive ripple effects throughout the economy for many years to come, our study (chart 1) shows that profit taking in the equity market could occur once the higher rating is actually achieved. “Selling after the fact”, which is a common move by investors is possible, as market participants use the market momentum created by the boost to investment grade as an exit mechanism.

We note that on average, the index returns three months post the attainment of investment grade was negative 0.5 percent with South Korean market performing the worst down 26.4 percent, followed by the Thai and Chinese markets which fell 16.3 percent and 15.3 percent respectively. However, it is worth pointing out that in the case of South Korea and China, their market declines coincided with the Asian financial crisis.

Having said that, perhaps Brazil’s, India’s and Russia’s rating upgrades, having occurred in 2004-07, could serve as better proxies. In these cases, we also observe some market weakness three months post the rating upgrades in Brazil and India, before their stock market performances reaccelerated six months and 12 months thereafter. For Russia, the index decline unfolded only six months following the higher rating.

In conclusion, we expect periods leading up to the achievement of investment grade status to be good for stock markets in general. However, it is not immediately clear that the boost to investment grade could be sustained 3-6 months thereafter; therefore, requiring investors to be vigilant during this period.

However, over the longer run, we at Bahana believe that investment grade status will further bring down Indonesia’s risk premium and attract more capital inflows, which have been rising on the back of a responsible policy framework, resulting in faster output growth and reasonably well-contained inflation.

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