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India & Indonesia: both market reformers, but one more famous than the other

Charles and Diana. Sonny and Cher. Holmes and Watson. There are plenty of examples in which one half of a well-known partnership eclipses the other.

Perhaps we can add to the list Indonesia and India – the two Asian countries most investors associate with market reforms following the election of pro-business governments. Both markets are back from the brink after being labelled ‘Fragile Five’ economies a few years ago.

India – the world’s fastest growing major economy – tends to hog the limelight. Since Narendra Modi was sworn in as prime minister on May 26 2014, 10-year local currency government bond yields have fallen some 181 basis points, or 1.8 percentage point* (*as of Feb 28). Bond prices rise when yields fall.

India’s ability to tame inflation, boost foreign exchange reserves and improve the health of government finances is a great success story.

India’s ability to tame inflation, boost foreign exchange reserves and improve the health of government finances is a great success story. Wide-ranging reforms designed to make the country an easier place to invest and do business also made good progress last year.

However, the latest news coming out of Indonesia has given investors less cause for cheer. President Joko Widodo, who is better known as Jokowi, is facing a major challenge to his authority from opponents with an eye on the next general election in 2019.

The blasphemy trial of Basuki ‘Ahok’ Purnama, the ethnic-Chinese governor of Jakarta and a staunch ally of the president, is widely seen as an attempt to weaken the reform-minded Widodo. The trial has turned Purnama’s bid for re-election this year from a formality into an uncertain race marred by heightened religious and ethnic tensions.

The gubernatorial race is due to go to a second round next month (April 19) after each of the three candidates failed to secure 50% of the votes in an earlier round of voting. A verdict in Purnama’s trial is due the following month (May).

This political drama is an unfortunate distraction because economic conditions have been getting better for some time, even as global uncertainties ranging from Federal Reserve rate hikes, Donald Trump’s inflationary policies and potential commodity price volatility, cloud the short-term outlook.

Improving and manageable current account and fiscal deficits, and progress in infrastructure development have made Indonesia more appealing to investors.

Improving and manageable current account and fiscal deficits, and progress in infrastructure development have made Indonesia more appealing to investors since Widodo became president. The country is also less exposed to US trade policy because the economy relies more on domestic consumption, while the US is a relatively unimportant export market.

In fact, Moody’s Investors Service upgraded Indonesia’s sovereign rating outlook to positive from stable last month (February 8). The credit rating agency cited better policy effectiveness, economic stability and fiscal discipline for the decision. Finance Minister Sri Mulyani Indrawati, a former World Bank managing director, has been instrumental in getting government finances into better shape.

Last year, Indonesian sovereign and corporate local currency bonds delivered the best total returns out of 11 Asian markets in US dollar terms – some 17%1 – as yield-hungry investors piled into emerging market debt. Bank Indonesia, the central bank, cut its benchmark interest rate six times to support growth in 2016, making bonds relatively more attractive to investors.

While this performance is unlikely to be repeated this year, our six-month total return forecast for 10-year local currency sovereign bonds is 6%2 in dollar terms, rising to 8%2 for 15-year paper. The bond market and the rupiah have been, and continue to be, uncharacteristically stable. Food for thought, perhaps, for bond investors looking for ways to protect themselves against rising US rates.

There are, of course, risks. In addition to those already mentioned, this is a market that has a relatively high level of foreign participation – some 30%2 of Indonesian bonds are owned by foreign investors. In India, this is just 5%2. This means the Indonesian market, and the currency, are vulnerable to capital outflows. As we have seen before, sentiment towards emerging markets can change almost overnight.

Meanwhile, we don’t expect Bank Indonesia to cut rates this year. With inflation running close to 3%1, towards the bottom end of the central bank’s target range, policymakers can afford to keep something in reserve in case overseas volatility necessitates further monetary easing.

Indonesia was once derided as one of the five emerging markets most vulnerable to capital flight. A combination of sensible economic policies, a commitment to reforms and a lucky break from recovering commodity prices has helped produce a remarkable turnaround.

Although the less glamourous of Asia’s fixed income dynamic duo, the Indonesian bond market has rewarded investors handsomely. It’s about time it received proper recognition.

1Source: Bloomberg

2Source: Aberdeen Asset Management





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