I

ndonesia'€™s equity market is the most vulnerable to capital outflows in Southeast Asia, a US-based
investment bank says, ringing alarms for policy-makers bracing for more volatility in the financial
markets.

Morgan Stanley said it downgraded the outlook of the equity market to '€œneutral'€ from '€œpositive'€ on account of the rise in global risk-free rates, currency volatility and the resulting increase in equity risk premiums.

Morgan Stanley described the stock market as '€œover-owned'€, noting that the Jakarta Composite Index (JCI) had the most expensive price-to-book ratio among its peers in emerging market economies.

That situation, coupled with the high foreign ownership in Indonesia'€™s stock and bond markets, has made the country '€œlikely to be the most vulnerable equity market within ASEAN in a sudden stop of capital outflows scenario'€, Morgan Stanley analysts, led by Yang Bai, wrote in a report released on Thursday.

Foreign investors have pulled Rp 20.1 trillion (US$2.03 billion) from the stock market throughout June in response to a statement by US central bank governor Ben Bernanke, who hinted at possible tapering in its quantitative easing policy that has pumped inflows into emerging economies.

In the fixed-income market, foreign ownership in government bonds in July declined by Rp 18.8 trillion from a month earlier, data from the Finance Ministry'€™s debt management office said.

'€œCapital outflows and rising real rates from recent QE [quantitative easing] taper concerns have exposed such macro vulnerabilities, or funding needs, forcing policy-makers to undertake fuel subsidy rollbacks and interest rate hikes,'€ Morgan Stanley said.

The JCI rose 0.1 percent to close at 4,581.93 on Thursday. A day earlier, the benchmark index dropped 3 percent after Bank Indonesia (BI) Governor Agus Martowardojo released a statement that hinted at the possibility of hiking interest rates during his board of governors meeting next week.

Though it has stabilized in recent weeks, the JCI was nevertheless still 12 percent lower than its historic high of 5,214.98, which it broke on May 20.

Further downside correction in the stock market and more foreign outflows should not be ruled out, said John Rachmat, the head of equity research at Mandiri Sekuritas. He predicted the JCI would decline to 4,000 by year'€™s end.

At present, the benchmark index was supported only by the short-term '€œeuphoria'€ over the government'€™s successful attempt at increasing fuel prices, he said on Thursday.

Meanwhile, Finance Minister Chatib Basri dismissed such notions, saying that Indonesia was vulnerable to the ongoing volatility in the global economy, though he stressed the importance for the country to reduce its dependency on hot money from portfolio flows.

'€œI personally believe that, by simplifying investment procedures and attracting more foreigners to come into the real sector, we could still increase our FDI [foreign direct investments] and strengthen our capital account position,'€ he said over the phone on Thursday.

Nevertheless, the huge economic costs from the sudden capital reversal has alerted policy-makers in
the region to the importance of capital controls '€“ a move to entrap foreign capital by imposing taxes on portfolio-related investments or capping transaction volume '€“ given the possibility that the present uncertainty might not end in the near future.

Chatib recently warned that the ongoing volatility in the financial market was here to stay, at least in the medium-run, noting that policy-makers would have to take '€œlong breaths'€ to cope with the situation.