Following Bank Indonesia'€™s (BI) recent unexpected move to lower interest rates, almost all global investors we spoke with recently are concerned about weakness in the rupiah, down nearly 7 percent year-to-date, making it the worst performing currency in the region (table 1).

These concerns are not unfounded particularly as Indonesia'€™s private external debt amounts to in excess of US$160 billion (table 2), up 13.5 percent year-on-year, surpassing the government'€™s external debt of $134 billion (table 3). Note that some 31 percent or $50 billion of this private external debt is short-term, which could cause difficulties for small and medium-sized enterprises (SMEs) in servicing their debt repayments. This, coupled with a high dependency of many SMEs on their procurement of US dollar-linked raw materials, could mean rising non-performing loans particularly for smaller banks going forward.

All of the fund managers we talked to are of the view that the US Federal Reserve will be on target to raise rates in June or July, particularly as the US unemployment rate has reached 5.5 percent, a level low even by historical standards. This suggests that the Fed will be raising rates sooner rather than later.

Meanwhile, there is continued political pressure on the ground to get BI to further cut rates by 50-75 basis points in an effort to support President Joko '€œJokowi'€ Widodo'€™s ambitious infrastructure-related projects.

Hence, investors are concerned about the rupiah amid possible lower local rates ahead.

At this stage, a decoupling between equity and currency markets (table 4) is unhealthy in our view. For the Jakarta Composite Index (JCI), our sensitivity analysis shows that with every 1 percent rupiah depreciation against the dollar, market earnings per share (EPS) growth will fall by 0.8 percent. This suggests that the recent JCI record highs are not accompanied by market EPS growth.

Against this backdrop, we believe either the rupiah will have to strengthen ahead or the index will have to fall. That said, we cut our market rating to '€œneutral'€, although we stick to our 2015 index target of 5,800, which we expect to rise in line with our market EPS growth of around 10 percent.

Currently, we advise investors to adopt a defensive stance in staples, telecommunications and infrastructure plays, which are relatively immune to rupiah fluctuations. While US dollar counters may benefit from a weak rupiah, we think policy risks (higher royalties) and unexciting commodity prices remain challenging ahead.

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The writer is senior associate director/head of research at Bahana Securities

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