Indonesia

Despite very low inflation, Bank Indonesia raised its policy rates last month to support the currency. The strategy did not work before and will not work now. Stay short the rupiah.

The geopolitical backdrop remains negative despite some marginally less negative news. China’s stimulus is not yet large or fast enough to prevent a market riot. Two of our preferred equity regions, ASEAN and Europe, are struggling to outperform. Investors should stay defensive overall.

An unprecedented trade surplus has given Indonesia a rare opportunity to transition into a lower real rates regime. The sustainability of Indonesian stocks outperformance is contingent upon whether the authorities can do so.

Indonesian equity outperformance was predicated on an unprecedented trade windfall, including coal exports. As that fades, both the stocks and the currency are highly vulnerable.

Special Report

Executive Summary Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Chart 4Opinion Shifts Against China In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China​​​​​​ Chart 8China Threatens ASEAN With Import Substitution​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP​​​​​​ Chart 12BProductivity And Potential GDP​​​​​​ Chart 13Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China​​​​​​ Chart 15Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Indonesia’s Balance Of Payments Will Be Under Pressure Indonesian domestic demand is struggling in the face of tight policy settings. High real borrowing costs are constraining credit growth, and hurting non-financial sectors. Monetary authorities have shown little intention to reduce borrowing costs by any good measure, and remain focussed on exchange rate stability. This is a major policy dilemma that the authorities need to break free from before this bourse can embark on a sustainable bull market. Indonesia’s only bright spot since the pandemic, its external accounts, will be deteriorating. Capital inflows will dwindle at a time when the current account balance is set to slip back into deficit. This will put downward pressure on the rupiah, which in turn raises the risk of policy error as the central bank might be tempted to raise rates in a bid to stabilize the currency. Doing so would hurt economic growth and stock prices.  Bottom Line: Currency investors should stay short the rupiah versus the US dollar. Equity investors should wait for relative weaknesses before considering an upgrade in EM and Emerging Asian portfolios. Investors should stay underweight Indonesia in EM local currency bond portfolios. Sovereign EM credit investors, however, should continue to overweight Indonesia. Feature In the past few months, Indonesian stocks have rallied to a pandemic-era high. They have outperformed their emerging market peers as well, albeit from a very low level (Chart 1). Could this mean that Indonesia’s decade-long underperformance is finally coming to an end? We are not convinced. The nation’s equity index in US dollar terms will find it hard to advance to new highs anytime soon. Absolute return investors, therefore, should not chase this bourse up. In terms of relative performance, odds are that some of the recent gains might be lost. The recent outperformance had more to do with investors fleeing Chinese stocks and Indonesia has been one of the major beneficiaries of this rotation (Chart 2). Meanwhile, Indonesia’s policy setting remains quite restrictive. Its external tailwinds are receding as well, which is making the rupiah vulnerable. Chart 1Indonesian Stocks Are Still Not Geared For A Sustainable Bull Market Chart 2Much of The Indonesian Outperformance Had To Do With Investors Leaving China That said, given Indonesia’s drawn-out equity underperformance since early 2013, this bourse’s relative bear market versus the EM benchmark is late. As such, following near-term weaknesses, asset allocators should consider upgrading this bourse from underweight to neutral in EM and Emerging Asian baskets. Domestic bond investors should stay underweight Indonesian local currency bonds in EM and Emerging Asian portfolios. Sovereign credit investors, however, should remain overweight Indonesia. Persistent Domestic Headwinds The recovery in Indonesian domestic demand has been quite slow over the past two years. The top panel of Chart 3 shows that the economy is still struggling. Two years into the pandemic, consumer confidence and retail sales volume are well below pre-pandemic levels. One reason for the muted consumer sentiment is meagre growth in household income. Nominal wage growth has stalled, sapping consumer demand. Wage growth in real terms (deflated by headline CPI) is shrinking outright (Chart 3, bottom panel). Weakness is palpable on the supply side as well. The capacity utilization rate for both manufacturing and other industries remains well below pre-pandemic levels (Chart 4, top two panels), despite the fact that Indonesia’s manufacturing exports have been very strong over the past year (details to come). This underscores the extent of the weakness in domestic demand. Chart 3Consumer Confidence Is Low As Household Income Is Moribund Chart 4Low Capacity Utilization And Labor Usage Points To Poor Domestic Demand Chart 5Fiscal Support Is In Short Supply In line with low capacity utilization, labor usage has also been consistently below par since the onset of the pandemic (Chart 4, bottom panel). That means hiring has been restrained and workers have had little bargaining power, which explains why nominal wage growth has halted. The restrictive macro policy is also exerting a considerable drag on economic recovery. Indonesia’s fiscal stance is rather tight. The government is planning to rein in the fiscal deficit this year to 4.3% of GDP from a revised 4.7% deficit last year. As such, the IMF estimates that the cyclically adjusted fiscal thrust will be a negative 0.9% of potential GDP this year, and a further negative 0.6% next year (Chart 5).  Monetary policy, as we have repeatedly asserted, has remained extremely restrictive for the past six to seven years. Interest rates are prohibitively high.Banks’ lending rates, for instance, have consistently stayed above nominal GDP growth rate since 2012. That will likely be the case going forward as well given the muted growth outlook. If one looks at real bank lending rates (deflated by core CPI) vis-à-vis real GDP, the picture looks even more grim (Chart 6). Such high borrowing costs, which continued for a decade, have been a major headwind for the country’s non-financial sectors. Stock prices of non-financial firms as well as those of SMEs – which had to endure chronically high financing costs − have been in a decade-long bear market in absolute terms. By contrast, banks benefited from the high lending rates, and their share prices have rallied to their pre-pandemic highs (Chart 7). Chart 6Borrowing Costs Have Been Persistently High Relative To The Economy's Growth Rate... Chart 7...Hurting Stocks Of Non-Financial Firms And SMEs, While Benefitting Banks Chart 8Exorbitant Borrowing Costs Have Led To A Stagnation In Credit Penetration Very high real interest rates is one reason Indonesia’s credit penetration, at 34% of GDP, is unusually low for an economy at this stage of development. The ratio has not risen at all in the past 10 years. In fact, it has headed lower recently (Chart 8). This is not a sign of a healthy, recovering economy. As such, for Indonesian stocks to have a sustainable bull market, one of the macro imperatives is that the real borrowing cost needs to decline considerably. Yet, Indonesian monetary authorities have shown little intention to reduce real rates by any meaningful measure. The main reasons behind this hawkish stance on the part of the central bank has had to do with (i) the country’s persistent current account deficit over the past decade, and (ii) the central bank’s mandate of exchange rate stability. Indonesia needed to offer consistently high real rates to attract enough foreign capital so that it can finance its current account deficits, and thereby have a stable rupiah. Yet, that policy has created distortions elsewhere. Persistently high real rates have led to a steady drop in non-financial firms’ return on equity. That, in turn, discouraged foreign equity inflows but encouraged international fixed-income inflows into Indonesia. This is not surprising as equity investors dislike high real rates, while debt investors prefer it. The reliance on foreign debt inflows, in turn, incentivized the authorities to keep real interest rates persistently high − even in periods when growth was rather timid and inflation undershot the central bank’s target. This is a major distortion that the Indonesian economy needs to break free from before this bourse can embark on a sustainable bull market. Incidentally, a bill to expand the central bank’s mandate to include growth and employment was introduced to parliament last year. If passed, the bill-turned-law would allow Bank Indonesia to set interest rates more in line with domestic economic conditions, rather than just focussing on currency stability. Chart 9Inflation Is Inching Up From Very Low Levels Discussions on the bill, however, have been delayed in  Parliament, and it is not clear when, or if, it will be passed. Meanwhile, Bank Indonesia has begun to tighten policy on the margin by draining excess liquidity from the system. More worryingly, the central bank could begin to raise rates in the next couple of months as it fears inflation will creep up due to rising global commodity prices (Chart 9). Outflows from the bond market might also encourage the central bank to raise rates in an attempt to stem them (details in the next section).   Receding External Tailwinds In contrast to Indonesia’s lack of domestic recovery, the country’s external sector was the star performer over the past year or two. Yet, in the next few quarters, it’s the external sector that will likely be a threat to the nation’s growth. This is because Indonesia’s exports are set to shrink and its balance of payments is set to deteriorate. These factors could threaten the rupiah stability, which would then force the central bank to raise rates / tighten liquidity prematurely in a bid to support the rupiah. Tighter policy would be a major headwind for growth, and would hobble stock prices.  Indonesian exports grew remarkably over the past two years, which helped to push the country’s current account balance into surplus for the first time in a decade (Chart 10, top panel). A closer look, however, will reveal that much of it had to do with surging exports to China – which doubled to $55 billion in two years (Chart 11). Chart 10Indonesia's Balance Of Payments Will Be Under Pressure Chart 11Improvements In The Current Account Were Mostly Due to A Surge In Exports To China           That said, much of the improvements in the current account could unravel going forward: Some of the export windfalls accrued to Indonesia when China banned Australian coal imports in 2020 and switched to Indonesian coal instead.   But more recently, a decelerating economy in China has led to slowing electricity generation. The latter has always had a direct bearing on Indonesian coal exports volume – which is now shrinking (Chart 12, top panel). China’s electricity demand and production will slump further due to COVID lockdowns of enterprises and pending weakness in its exports. Chart 12Export Windfalls Are Ending As Chinese Growth Wanes Chinese thermal coal prices have been falling in recent months from the sky-high levels of late 2021, and could fall further by the end of the year as China keeps increasing its own coal output and its electricity generation drops (Chart 12, bottom panel). All these will weigh on Indonesian export earnings in the months to come. For its part, the Indonesian government has restricted coal exports by mandating that miners set aside 25% of their output for local sales as part of their “domestic market obligation.” The government has also banned shipments of some palm oil ingredients for an indefinite period – in an apparent attempt to check domestic food price inflation. Palm oil is the second largest Indonesian export after coal, and together they make up 22% of total export revenues. Indonesia is a large net crude and refined petroleum importer. Global crude prices will likely stay elevated due to sanctions on Russia. This will be a negative for the country’s trade balance. Chart 13Dwindling Goods Demand In The Developed World Will Hurt Indonesian Manufacturing Exports Moving beyond commodities, Indonesian manufacturing exports − which are as large as its’ commodities exports in US dollar terms − will also likely get hurt. A crucial reason for that is a slowing China. Chinese manufacturing imports are set to weaken in the next several months as that economy is entering a soft patch. That usually is an adverse development for Indonesian exports to China (Chart 13, top panel). In fact, Indonesia’s overall manufacturing exports will also likely slow. Falling household goods demand in developed countries will curtail manufacturing exports from Asia, including Indonesia. Notably, early signs of an impending slowdown in Indonesian manufacturing exports often appear in Chinese data − given the heft of the Chinese economy and its trade links in Asia and beyond (Chart 13, bottom panel). More generally, global trade will likely slow going forward, which is a negative for those economies that have relied on an export windfall over the past couple of years. Essentially, the days of boyant current account balances are numbered for Indonesia.  A slipping current account balance could spell larger problems for Indonesia as the country’s financial account surplus has been steadily eroding. From a high of $37 billion annually in 2019, it dropped to just $12 billion by the end of 2021. Much of that drop is due to a fall in net debt inflows – the type of capital inflows Indonesia strives to attract by keeping real interest rates very high (Chart 10, middle panel). Chart 14Falling Real Bond Yields In Indonesia Will Keep Foreign Debt Investors At Bay Critically, the country has not been able to attract much FDI either despite passing an Omnibus Law to boost new investments and create jobs a couple of years back (Chart 10, bottom panel). Chart 14 shows that foreign investor holdings of Indonesian government debt has shrunk materially from almost $80 billion in early 2020 to less than $60 billion now. In terms of their share in total bonds outstanding, the drop is even more remarkable: from 40% of the total to just 18%. Foreign bond purchases clearly react to the ebbs and flows of Indonesian real yields on offer (Chart 14, bottom panel). Given that Indonesian inflation will likely go up from the current very low levels − putting a downward pressure on the real yields available – foreign investors could continue to shun Indonesian bonds. Indonesian policymakers might also worry as such. That apprehension could prompt Bank Indonesia to raise rates preemptively in a bid to attract debt inflows and stabilize the currency. If so, higher real rates would add to the existing policy headwinds for the domestic economy. Growth will suffer; and markets will sell off.  Investment Conclusions The Currency: The rupiah remains vulnerable as the Indonesian balance of payments is set to deteriorate. A slipping current account balance amid receding capital inflows will be putting downward pressures on the rupiah. Stay short the rupiah versus the US dollar. Domestic Bonds: Indonesian bond yields have fallen massively relative to their EM counterparts, and are at 10-year lows in relative terms. As such, the nation’s local currency bonds have little more room to benefit from relative yield compression. The rupiah is also vulnerable. We went underweight Indonesian domestic bonds in November last year, and that recommendation remains in place (Chart 15). Sovereign Credit: Absolute return investors should reduce their exposure as the rupiah weaknesses going forward could lead to widening credit spreads, and result in negative total returns in US dollar terms (Chart 16). Chart 15Stay Underweight Indonesian Domestic Bonds In An EM Bond Portfolio Chart 16Absolute Return Investors Should Reduce Exposure To Indonesian Sovereign Credit   Asset allocators, however, should stay overweight Indonesia in an EM credit basket. This market has transitioned itself into a defensive one over the past several years – thanks to years of orthodox fiscal and monetary policies and low debt. Hence, given that a period of risk-off is around the corner – during which Indonesian credit tends to outperform as it did in 2015 and 2020 − it makes sense to stay overweight this market. Stocks: Absolute return investors should not chase this bourse up. Asset allocators should wait for relative weaknesses before considering an upgrade from underweight to neutral in EM and Emerging Asian portfolios.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com