By Vidya Ranganathan
Investors in Indonesia are a facing a tricky manoeuvre balancing their bullishness on the economy with fears the currency is set to weaken this year, and are finding the best option is to cut exposure to rupiah-denominated assets.
Foreign investors have been cutting exposure to rupiah bonds and stocks for weeks, suspending a long spell of bullishness based on Indonesia's high yields, strong growth and its swift ascension into the investment grade club.
Fund managers have been distancing themselves from the rupiah market too, moving to neutral or even underweight positioning.
So when the same set of investors lapped up a $2.5 billion global dollar bond issued by Indonesia late in April, it was clear that their doubts and unease lay not with the fundamental attractiveness of Southeast Asia's largest economy, but rather with assets denominated in the local currency, the rupiah.
"This year won't be the year for Indonesia," said Arnout van Rijn, chief Asia-Pacific investment officer for Robeco.
Foreigners hold about a third of local bonds, which exposes the $84 billion market to a brutal sell-off should the global risk environment change. And the burden of servicing foreign creditors is burning a hole in Indonesia's external account, which is already hurting from slowing exports.
The central bank's somewhat unusual policies are part of the problem. It appears to have cut rates too much, oil prices are almost certain to push inflation higher, and no one's quite sure when Bank Indonesia will ease its tight grip on the rupiah.
"It seems to have become consensus now that Indonesia's policy is not heading in the right direction, but I don't think they are ready to retrace on any of their policies yet," said van Rijn.
"Until that policy changes, I don't think we will move from our underweight position."
Robeco, which has $2 billion under management in Asia, has been underweight Indonesian equities since the second half of 2011.
Mutual funds and other foreign players have pulled money from the Jakarta stock market in the past month, extending a trend seen in 2011 when their net investments dropped by almost half to about $1.3 billion.
Fund managers at Aberdeen Asset Management are neutral to slightly underweight Indonesian debt. Likewise, Schroders' fund manager Rajeev De Mello is staying away from both the rupiah and Indonesian government bonds for now.
Although an auction of 6 trillion rupiah ($650 million) of debt on Wednesday was well-received, foreign appetite has been gradually waning. Offshore investors have pared their holdings of rupiah debt down from as much as 35 percent of the market to 29 percent currently.
Bank Indonesia does not disclose the levels of foreign participation at its bond auctions. But responses at successive auctions have been lukewarm and bid-to-cover ratios have plunged. The government has astutely decided it will issue more global dollar bonds this year to meet its funding needs.
Rupiah debt yields have fallen, masking the declining interest, due to lower policy rates, rising money supply and the bids from benchmarked fund managers who are obliged to stay invested in Indonesia by their investment guidelines.
Ten-year bonds used to yield 9.3 percent early in 2011. Now they yield 5.9 percent. For any investor who feels the odds of the rupiah depreciating are relatively short, buying rupiah debt just doesn't make sense, simply because it can cost 5.6 percent to hedge the rupiah risk in offshore non-deliverable forwards.
TAKE NO RISKS
Although Indonesia did post its first current account deficit in four years in the final quarter of 2011, it was a modest 0.4 percent of GDP. Rising imports are not unexpected in an economy where growth is surpassing expectations and which is investing heavily in industrial capacity.
However, closer scrutiny shows bond coupon payments to foreigners, dividend payments to overseas equity investors and the servicing of rising amounts of cheap dollar loans are keeping Indonesia's external income account in a deep deficit.
So even those who see some short-term value in rupiah-denominated bonds are wary of standing on the wrong side of a market in which others are rapidly cutting positions and there is a view that the currency is set to weaken.
"The choice is to pick pennies in front of a steamroller or stay neutral," said one fixed income strategist who didn't want to be named.
CitiGroup economist Helmi Arman predicts the rupiah will drop to 9,370 by the end of 2012. It was trading around 9,200 per dollar on Thursday.
Morgan Stanley currency strategist Stewart Newnham expects the rupiah to decline to 9,550 by the third quarter because the income account will exert pressure on the balance of payments even if foreign holdings of bonds fall.
Export earnings aren't rising because the rupiah is too expensive. Bank Indonesia's heavy intervention has essentially kept it in a tight 8,800-9,200-per dollar range since October last year.
That policy, and a heavy pro-growth tilt, may prove to be counterproductive. As Bank Indonesia cut interest rates by a percentage point between September 2011 and February 2012, foreigners went from being overweight to underweight the bonds.
The more Bank Indonesia intervened to keep a tight rein on the rupiah, the more it exposed its concerns about potential capital outflows and that made investors edgy. Now they worry the rupiah market just isn't liquid or deep enough.
Those still invested are willing to give Bank Indonesia the benefit of doubt for now. Expectations for volatility and rupiah depreciation are modest, even if the widening current account gap reminds some of 2008 and the crisis in 1997/98, when the currency was attacked viciously by speculators.
"While top-line macro data appears strong, underneath the economy has begun to experience the same destabilizing financial engineering that preceded the 1998 Asian financial crisis," Sean Darby, chief equity strategist at Jefferies.
"A change in the terms-of-trade would have a far more disruptive effect on the economy than equity markets are discounting," Darby said in a recent note, adding he'd initiated cover on Indonesian equities with a bearish view. ALB
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