Key Political Risks to Watch in Indonesia

By Nick Chatterjee, Reuters

A booming economy, falling debt and market-friendly reforms could see Indonesia secure an investment grade credit rating as early as this year, putting it on a par with BRIC nations and enabling more institutional interest in its bonds.

That trajectory, however, is threatened by vested interests who stand to lose out if measures aimed at increasing transparency and creating a level playing field succeed.
In January, investors took profits on last year’s rally in Indonesian markets, and fund outflows could accelerate if policy makers fail to keep a lid on inflation. Following is a summary of key Indonesia risks:

Central Bank Policy and Inflation

The central bank has changed its tune in the past month on its key policy rate — held at a record low of 6.5 percent for over a year to drive growth- saying that it will not hesitate to tighten policy if core inflation nears 5 percent. Last year its stance was that the rate was appropriate to meet its inflation target for the next two years.

This has not been enough for investors, who dumped Indonesian blue chip stocks and bonds in January on worries the central bank would be behind the curve in tackling inflation, a historic Achilles heel for the country, in favor of Asian countries seen as having a better grip on price pressures.

Inflation, often compounded by the problems of transporting food and goods across a vast archipelago with poor infrastructure, hit a 20-month high near 7 percent in December, though is seen holding steady in January after the government distributed more rice and urged people to grow their own chillies.

Economists are calling for a rate hike by the second quarter to head off inflationary pressures, though the central bank has insisted rate hikes are an option of last resort and it would prefer to tighten through other measures such as further lifting bank reserve requirements following China.

The central bank worries hiking rates would increase the allure of the country’s assets for yield hungry investors, lifting the proportion of foreign holdings and leaving the country even more at risk of sudden capital outflows if risk sentiment changes.

If January inflation builds further and the central bank stands still at its policy meeting on Feb. 4, this could spur renewed selling and weaken the rupiah. Previous bouts of capital outflows hammered the rupiah, destabilized the economy, and led to sharp rate hikes.

Inflation data, particularly if core inflation nears 5 percent, and any change in nuance in policy statements.

New soft controls by the central bank to limit volatility by slowing capital inflows.

Moves by the government to head off food price pressures in other ways, such as importing more rice.

Government Effectiveness in Driving Reform

When President Susilo Bambang Yudhoyono was re-elected with a strengthened mandate in 2009, many Indonesians hoped the former general would use his second and final term to shore up his legacy as a progressive reformer. Soon after his second term began, however, the government was distracted from policy making by a long and highly politicized enquiry into a bank bailout that led to the resignation of one of his top reformers, former Minister Sri Mulyani Indrawati.

In the past year parliament has passed only 17 out of 70 bills targeted, and the government’s ineffectiveness at passing laws is emerging as a growing risk to reform. A long awaited bill on land reform, which could encourage vital investment in infrastructure, reached parliament in December, but the body shows no signs of discussing it so far this year. The parliament also missed an end-2010 deadline to pass a bill creating a new financial regulator, with a dispute over its composition worrying banks.

A plan to limit forest clearance from January 1, under a $1 billion climate deal with Norway, has also yet to be signed into law.

What to watch:

Progress on the passage of the government’s new land acquisition bill that would set time limits on negotiations over land deemed crucial to public interest. Despite broad support for the bill, it may be as late as 2012 before it comes into effect.

Whether the government can improve infrastructure by attracting investors into private-public partnerships. Yudhoyono has said he would boost infrastructure spending in 2011 by 28 percent from 2010 levels, and both Japan and India have since announced planned investments.

How much opponents of reform, including those within Yudhoyono’s ruling coalition, manage to block other pro-investment policies such as changes to the rigid labour laws and cuts in energy subsidies.

Progress with tax cases, since those involving Bakrie’s companies such as Bumi Resources, appear to have stalled.

Corruption and Governance

Yudhoyono was elected on promises to tackle graft, but early in his second term the Corruption Eradication Commission (KPK) has been under attack with attempts by senior law enforcement officials to frame two KPK leaders. Many felt Yudhoyono was slow to defend his top graft-busters.

Transparency International’s latest Corruption Perception Index (CPI) put Indonesia’s score at 2.8 out of 10 — the same as in 2009 — signaling a perception that there has been no progress on tackling corruption.

In late November parliament choose soft-spoken academic Busjro Muqoddas to be the new head of the KPK, but gave him just a year to complete the tenure vacancy caused by the jailing of his predecessor, Antasari Azhar, for murder.

Yudhoyono followed up the KPK appointment by naming Basrief Arief as attorney general — a position that is meant to try graft suspects — but the choice of an internal candidate disappointed campaigners, who said this signalled the?president was not committed to reform.

A jail sentence of 7 years for Gayus Tambunan, a minor tax official who shocked the nation by bribing his way out of prison while under investigation for taking bribes to cut corporate taxes, disappointed many and the case revealed the continued depth of institutional graft. Gayus faces a slew of other charges but says he is a scapegoat.

The KPK’s arrest in January of 16 current and former members of parliament for alleged involvement in bribery will be the next test of whether it can prosecute bigger corruption cases.

What to watch:

How the new KPK chief performs and how the anti-graft body uses new powers to investigate unusual financial transactions.

The effectiveness of the presidential delivery unit in tackling legal reform and other issues that deter investors.

The pace of reform of Indonesia’s civil service, police and courts. Investors have already had to adjust expectations.

Security

Suicide bombings at two luxury hotels in Jakarta in July 2009 were the first major attacks in Indonesia since 2005 and raised concerns that the threat from militants was again on the rise.

Since then, the killings of Noordin Mohammad Top and, more recently, bomb-making expert Dulmatin, have significantly reduced that threat, but some risk persists.

Last year, police discovered a network of armed militants operating a training base in Aceh, Sumatra province. The group wanted to create an Islamic state, police said. Police also captured preacher and suspected Aceh group member Abdullah Sonata, who had previously been jailed.

Firebrand cleric Abu Bakar Bashir was also arrested last August for allegedly supporting and financing the Aceh group. Police have failed in the past to pin terrorism charges on Bashir, and analysts say it is crucial they back up the charges this time, or risk turning Bashir into even more of a martyr. His trial was due to start early this year, though no date has yet been set.

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