The lure of Indonesian investment

Foreign investors are continuing to flock to Indonesia. Strong and improving economic fundamentals, public sector deleveraging, plenty of external liquidity and prudent macroeconomic policies make the country attractive.

Last year the vast archipelago's economy grew 6.5 percent, the highest since 1996, -- the year before the Asian financial crisis struck. Growth in private consumption, stronger investment, and rising exports all contributed. ADB expects the economy to expand 6.4 percent this year and 6.7 percent in 2013.

Foreign investors have closely monitored these accomplishments, as have credit rating agencies Moody's Investors Service and Fitch Ratings, both recently boosting Indonesia's sovereign credit rating to investment grade.

Foreigners own some 60 percent of the shares traded on Indonesia's stock exchange. And they hold one-third of all local currency (LCY)-denominated government debt. The Jakarta Stock Exchange Composite Index gained 3.2 percent in 2011 and is up 8.8 percent so far this year. Yields on Indonesian government bonds are third highest in Asia -- after India and Vietnam.

Continued accommodative monetary policy combined with low returns in mature markets will keep foreign portfolio investors investing in emerging markets like Indonesia -- particularly those that have undergone significant capital market reforms and are strengthening macroeconomic fundamentals in support of domestic demand-led economic growth.

Last month, the Organization for Economic Cooperation and Development (OECD) upgraded its Country Risk Classification for Indonesia, which now stands alongside Brazil, India, Peru, Russia, South Africa, Thailand, and Uruguay.

How the country survived the crippling 1997/1998 Asian financial crisis -- and has thrived since -- offers lessons for developing economies struggling to attract investors. The development of the Indonesian rupiah bond market -- a favorite of foreign investors -- is a case in point.

Indonesia had no government bond market prior to 1997, as the government required a balanced budget, thus prohibiting the issuance of LCY bonds. The crisis aftermath overhauled the financial system, allowing the issuance of recapitalized bonds that ultimately kick-started the domestic bond market development.

Indonesia's bond market has grown steadily since. It now offers a diversified array of debt instruments catering to a broader investor base. Total LCY bonds outstanding grew 3.6 percent in 2011, worth the equivalent of US$110 billion.

Large capital inflows are fine so long as they stay put. So Indonesia is trying to moderate the massive inflow of foreign funds, managing liquidity by gradually replacing short-term Bank Indonesia certificates with longer-term government bonds.

Market growth in recent years has been driven by the smaller corporate bond market, which expanded 28 percent in 2011. Indonesia's bullish economic prospects, recently upgraded sovereign debt ratings, and falling yields should encourage more local companies to raise funds through bond sales.

Yet the corporate bond market structure remains skewed with the top 30 companies accounting for nearly 80 percent of total private debt outstanding. Also, there is a lack of corporate bond market liquidity, which remains a major concern.

Indonesia has gone through a series of ambitious bond exchanges, debt buybacks, and debt switches. Since 2003, the government ran debt buybacks to stabilize the market and reduce the level of public debt outstanding. In 2005, it began debt switches to reduce refinancing risk. And as a result, Indonesia is the only country in emerging Asia with over 40 percent of its outstanding public debt in maturities beyond 10 years.

Increased LCY borrowing and less reliance on foreign currency borrowing has helped greatly reduce the "twin mismatches" in currencies and maturities that were the root cause of the 1997/1998 crisis. The share of government financing from market sources is expected to increase to about 85 percent this year, from 60 percent in 2009, in line with official policies to develop the capital market.

The rapid development of the LCY bond market has reduced risks associated with excessive reliance on short-term external financing. The LCY bond market is an alternative to banks for channeling domestic savings into productive long-term investment -- particularly for infrastructure. Finally, market development is also supporting economic and financial integration in East Asia.

Looking ahead, I am confident Indonesia will build on its successes and move closer toward joining the ranks of higher income economies. Progress in tackling structural weaknesses and addressing development challenges through sustained economic growth -- particularly reducing poverty and narrowing inequality -- would boost Indonesia's economic and sovereign credit fundamentals and make its assets more attractive to foreign investors.

The future of Indonesia's growth and development will be shaped by the government's continued progress in redirecting and improving the quality of its spending. Effective spending on infrastructure, education, health, along with measures to improve the business climate, could ensure Indonesia's annual growth rate is consistently between 6 percent and 7 percent -- perhaps even higher.

Let me add a very important word here. That word is "knowledge". Globalization has oiled the wheels of trade, investment, and finance, and production efficiency. But it has also eased the transfer, adaptation and productive use of knowledge -- the internet notwithstanding. In most cases, no one has to reinvent the wheel.

For the rest, there is innovation. Exchanging knowledge and investing in research is germane to national development -- it is central to avoiding the so-called "middle income trap". It is the essence of regional cooperation and integration, fine-tuned to the specific needs of individual economies. In short, increased investment in knowledge will also help drive Indonesia's future growth.

Engaging in needed structural reforms and overcoming development gaps will push Indonesia's economy toward a sustained higher growth path. It is predicated on the benefits and opportunities generated being shared equitably -- to bring greater prosperity across this vast archipelagic nation.