FACTBOX-Key political risks to watch in Indonesia

By Sara Webb and Sunanda Creagh

JAKARTA, July 1 (BestGrowthStock) – Strong growth and political
stability made Indonesia Southeast Asia’s most attractive
investment destination last year, but the outlook is threatened
by a struggle between reformers and powerful vested interests.

Top reformer Sri Mulyani Indrawati’s decision to quit in
May, fed up with the pressure from the political old guard, was
a setback. But no major problems have emerged in the economy
since her departure and her successor as finance minister, Agus
Martowardojo, is no pushover, so prospects for continuing her
work and achieving an investment grade credit rating are
strong.

The sovereign credit default swap spread (IDGV5YUSAC=R: ),
has widened since May mainly due to euro zone concerns, and has
been trading at around 180 basis points.

The rupiah (IDR=: ) has strengthened from 12,600 per dollar
in November 2008 to trade at about 9,060 by the end of June.
The benchmark stock index (.JKSE: ) has surged 2.6 times from its
Oct. 28, 2008 low and reached an all-time high on May 4.

Following is a summary of key Indonesia risks to watch:

* GOVERNMENT EFFECTIVENESS IN DRIVING REFORM

President Susilo Bambang Yudhoyono, re-elected with a
strengthened mandate last July, is widely seen as a
progressive, market-friendly reformer. Many investors hoped the
pace of reform would pick up in his second term after he chose
Boediono, an economist, as vice president; gave two reformist
technocrats — Indrawati and Mari Pangestu — key cabinet
posts; and picked Kuntoro Mangkusubroto to head a new
presidential delivery unit.

Instead, his second term got off to a bad start. Boediono
and Indrawati — who had made many enemies among opponents of
reform, including Aburizal Bakrie, the businessman who heads
the Golkar Party — came under attack for their decision to
rescue a small lender, Bank Century, during the 2008 crisis.
[ID:nJAK447688]

A parliamentary inquiry into the case dragged on for
months, distracting the governments. Yudhoyono expressed full
support for Boediono and Indrawati, who had backed the bailout
to avoid a collapse of confidence in the financial sector.
[ID:nJAK443320]

However, the political pressure clearly took its toll on
Indrawati, who accepted a job at the World Bank. Soon after she
quit, Yudhoyono gave Bakrie a new post as coalition manager,
raising questions over his commitment to reform.
[ID:nJAK299378]

In June, Golkar proposed the creation of an ‘aspiration
fund’, under which lawmakers would each receive an allocation
of 15 billion rupiah ($1.66 million). Golkar said the money
would be used to fund development in the regions but critics
attacked it as pork barrelling and said the money would be
vulnerable to corruption. Martowardojo and other senior
ministers have opposed the fund but Golkar’s push shows it has
been emboldened by its success in getting rid of Indrawati and
that rifts within the ruling coalition continue to run deep.

Yudhoyono has shown a preference for incremental reforms
rather than bold action, disappointing some investors. However,
progress is slowly being made. In March, Boediono announced a
new team to oversee reform of the bureaucracy, a positive sign
for foreign investors, while Mangkusubroto has introduced
regular progress reports on ministers and their projects.
[ID:nJAK226817]

Also, healthy fundamentals and a large and growing domestic
consumer base still provide reasons to invest in Indonesia even
if reform progress is slower than had been hoped.

What to watch:

— Opponents of reform, including those within Yudhoyono’s
ruling coalition, will probably try to block pro-investment
policies such as changes to the tough labour laws and cuts in
energy subsidies. [ID:nJAK427204]

— So far there is no evidence that Bakrie’s new post gives
him more powers to try to block reform. Despite Indrawati’s
departure, prospects for reform under Martowardojo remain
reasonably strong. As head of Bank Mandiri (BMRI.JK: ), he took
on powerful tycoons and forced them to repay their debts. He
was quick to reiterate his commitment to sound macroeconomic
policies and to continuing Indrawati’s reforms. [ID:nJAK135796]

— Progress with tax cases, particularly those involving
Bakrie’s companies. [ID:nJAK389318]

— The future of the coalition. The Bank Century inquiry
strained relations between Yudhoyono’s Democrats and coalition
partners Golkar, many of whose members oppose reform, and PKS,
an party which sometimes takes a nationalist, anti-Western
stance.

* CORRUPTION AND GOVERNANCE

Corruption emerged as a defining issue at the start of
Yudhoyono’s second term, with popular anger mounting over a
power struggle pitting the respected Corruption Eradication
Commission (KPK) against the attorney-general’s office and
police. The KPK has made significant progress in investigating
corrupt officials, but this stirred powerful opposition.
Yudhoyono has vowed to back the anti-corruption drive but his
slow response to the KPK scandal disappointed many Indonesians
who wanted bolder steps.

Under Mangkusubroto, the presidential delivery unit and
legal task force has begun tackling legal reform, for example
exposing graft in the prison system and investigating officials
suspected of perverting the course of justice.

What to watch:

— Who heads the KPK next. A new chairman will be chosen
soon to replace Antasari Azhar, who was jailed for murder. With
the KPK still under attack from vested interests, it’s
important the job goes to someone with impeccable credentials.
[ID:nJAK149966]

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

— Pace of reform of Indonesia’s civil service, police and
courts. Yudhoyono’s cautious response to the power struggle
over the KPK suggests he will move much more slowly than
markets had hoped. Investors betting on more decisive reform
during Yudhoyono’s second term have had to adjust expectations.

* HOT MONEY AND CAPITAL CONTROLS

The rupiah was Asia’s best-performing currency in 2009 with
a gain of 17 percent against the dollar, threatening
Indonesia’s export competitiveness but helping to contain
imported inflation.

The rally continued for much of this year too, prompting
the central bank to intervene to stem the rupiah’s gains as it
traded around 9,000 per dollar. More recently, the sell-off in
the rupiah and other Asian currencies prompted the central bank
to intervene again by selling dollars.

Such capital flows are closely watched by the authorities.
Memories are still raw of the 1998 Asian crisis, which was
widely blamed in Indonesia on foreign “hot money” being yanked
from the country. In June, Bank Indonesia announced a range of
new controls aimed at keeping foreign money invested longer in
Indonesia, including a minimum one month holding period for its
SBIs and new 9-month and 12-month SBIs that will be made
available later this year. [ID:nJAK275824]

In March, Bank Indonesia began reducing the frequency of
auctions for one-month SBIs, so foreign investors have shifted
into three-month paper. [ID:nJAK197199]

What to watch:

— Data on exports and speculative inflows, and whether the
central bank’s measures for SBI auctions have the desired
effect of reducing volatile short-term capital inflows. If
problems arise, controls may be tightened. Draconian measures
that send investors fleeing to the exits are unlikely —
measures would be aimed at directing flows, rather than halting
them, so any negative impact on asset prices would be muted.
However, the issue can still spook markets — the rupiah
suffered its biggest one-day sell-off in nine months last
November due to mixed signals on capital controls.
[ID:nHKG263506]

* SECURITY

Suicide bombings at two luxury hotels in Jakarta last July
were the first major terror 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, the bomb-making expert Dulmatin, have
significantly reduced that threat. But some risk persists.

Earlier this year, police discovered a new network of armed
militants operating a secret training base in Aceh in Sumatra
province. The group was plotting to assassinate Yudhoyono and
government officials at an independence day celebration, and
wanted to create an Islamic state, police said. [ID:nJAK214087]

In late June, police captured preacher Abdullah Sonata on
suspicion of involvement in the Aceh group. [ID:nJAK59920].

Sonata had been jailed in the past but released early for
good behaviour. His return to militancy raises questions about
the effectiveness of Indonesia’s efforts to rehabilitate
captured militants. Police also uncovered a plan to attack a
European embassy and a police ceremony in Jakarta.
[ID:nSGE65O0E8]

What to watch:

— Ability of militants to regroup and launch more attacks.
Particularly if remaining militants are able to establish firm
enough links with al Qaeda or allies in Southeast Asia to
secure sustained funding, expertise and recruits, the threat
may be far from over. But Indonesia’s markets have proven
highly resilient to militant attacks. Unless there is a
significant and sustained deterioration in security, or
militants reignite sectarian unrest, any sell-off would be
limited and brief. [ID:nSP545301]
($1=9015 Rupiah)

(Editing by Andrew Marshall)

FACTBOX-Key political risks to watch in Indonesia