Triple Threat to Indonesia Turning Funds Off Worst Emerging Debt

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Slowing growth, accelerating inflation and a weakening currency are punishing investors in Indonesian bonds, the worst emerging-market performers.

Rupiah sovereign notes have fallen 6 percent over the last three months, more than twice as much as Philippines’ 2.2 percent loss that was Asia’s second-poorest performance, Bloomberg indexes show. The rupiah weakened 5.8 percent in 2015, leading declines in Asia, as the economy grew at the slowest pace in more than five years in the first quarter and inflation stayed above 6 percent all year.

The triple threat to Southeast Asia’s biggest economy also limits policymakers’ room for response. Vice President Jusuf Kalla called for Bank Indonesia to reduce interest rates “little by little” on Thursday, with central bank Governor Agus Martowardojo saying shortly afterward he would keep a tight monetary stance to anchor inflation. A surprise cut on Feb. 17 spurred outflows and pushed the rupiah down 3 percent over the next month.

“The challenge for foreign investors in rupiah bonds is managing the foreign-exchange risk as the outlook for the rupiah is negative,” Nagaraj Kulkarni, a senior rates strategist at Standard Chartered Plc in Singapore, said in a May 6 interview. “While slowing domestic growth presents a case for lower policy rates, Bank Indonesia needs to maintain a tight monetary policy to limit the current-account deficit and excessive rupiah weakness.”

Bond Ownership

The current account has been in shortfall for 13 quarters through the end of last year as prices for Indonesia’s commodity exports such as coal and palm oil dropped. The 2015 deficit will probably be 2.5 percent to 2.9 percent of gross domestic product, Finance Minister Bambang Brodjonegoro said May 4. That compares with 2.95 percent in 2014.

The high level of foreign ownership of Indonesian sovereign bonds, which reached a record 40 percent in January and was 39 percent on Wednesday, also makes Indonesia vulnerable to U.S. interest-rate increases. That compares with 31 percent in Malaysia and 18 percent in Thailand, according to the latest Asian Development Bank data.

“That creates risks as we get closer to the Fed hike,” Geoffrey Kendrick, Morgan Stanley’s Hong Kong-based head of Asian foreign-exchange strategy, said in an April 21 interview. “As Treasuries go higher that relative attractiveness starts to come unstuck.”

State Spending

The yield on Indonesia’s 10-year notes has surged 103 basis points, or 1.03 percentage points, in the three months through Friday to 8.19 percent, according to the Inter Dealer Market Association. That’s the highest level since December, before President Joko Widodo removed gasoline subsidies.

While the government estimated the move freed up 230 trillion rupiah ($17.5 billion) to be spent on ports, roads and other projects, it had only managed to spend 7 trillion rupiah in the year through April 27, 2.4 percent of the full-year goal, Finance Minister Brodjonegoro said April 28.

The statistics office cited the slow state spending as a reason why the economy contracted 0.18 percent in the first three months of the year from the previous quarter. On a year-on-year basis, GDP rose 4.71 percent, the least since 2009, data showed on Wednesday. The economy “urgently” needs rapid budget spending, Governor Martowardojo said Thursday.

Facing Dilemma

The slowing growth doesn’t necessarily mean Indonesia’s bonds will underperform, according to Pioneer Investments.

“We still think Indonesia has value,” Hakan Aksoy, a London-based bond fund manager at Pioneer, which oversees $244 billion globally, said in an e-mail interview Wednesday. “We still like duration risk in Indonesia and the Philippines.”

The cost to insure Indonesian sovereign debt against default using five-year credit-default swaps has risen 32 basis points to 166 since the end of February, according to data provider CMA. That compares with increases of four points to 120 in Malaysia and 10 points to 91 in the Philippines.

Indonesia has limited options to stem slowing growth, with further monetary loosening potentially risking instability, Fitch Ratings analysts led by Thomas Rookmaaker wrote in a note Thursday. “Macroeconomic stability is more important than higher real GDP growth for maintaining Indonesia’s BBB-rating.” That’s Fitch’s lowest investment grade.

Accelerating inflation also reduces the scope to cut borrowing costs. Consumer prices rose 6.79 percent in April from a year earlier, compared with 6.38 percent in March, official data show. Rising fuel and transportation costs were contributors, Bank Indonesia said in a May 4 statement

The rupiah is predicted to keep weakening. The currency will fall a further 2.6 percent to 13,500 a dollar by year-end, the median estimate in a Bloomberg survey shows.

“Foreign investors are waiting on the sidelines for the rupiah to stabilize and for a clearer outlook on the economy,” Ezra Nazula, who manages more than $2 billion as head of fixed income at PT Manulife Aset Manajemen Indonesia in Jakarta, said in an interview on Wednesday. “Indonesia is facing a dilemma as it tries to stabilize the economy.”

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