Indonesia: a long-term growth story

Indonesia’s recent stock market fall made the headlines, while investors have been worried about President Prabowo Subianto’s plans, which include diluting the central bank's independence. Veronique Erb, EM Equity Portfolio Manager, discusses why – despite the recent political transition causing uncertainty – the Indonesia equity story is a compelling one.

How much is recent market volatility a result of the EM rotation, and how much reflects concerns related to President Prabowo's political missteps?

While China has rallied year-to-date, Indonesia has underperformed, affected by political issues rather than just the capital shift to China. The recent sharp market drop was sparked by concerns over President Prabowo's new sovereign wealth fund (Danantara) and a growing military influence in government. The sell-off was the peak of a year of policy uncertainty and mixed messages from the president’s administration. The policy gap, between election confirmation in early 2024 to his late inauguration in October 2024, led to a lack of public spending.

Concurrently there was a crisis in microfinance lending, whilst weak commodity prices and stagnant wage growth also pressured the Indonesian consumer and market. Investors held on, anticipating regional monetary easing in response to US rate cuts. However, following the US election outcome, which suggested sustained high rates and a strong USD, ASEAN currencies weakened.

Now, Prabowo's policies, with a pro-growth socialist approach diverging from Jokowi's investment-led model are in effect, but investors are wary of the increased military presence in government, and Danantara. Recent clarity on the latter’s structure and management, including advisors like Ray Dalio, along with state bank board updates with credible technocrats, have prompted a market rebound. Attractive valuations offer some optimism, but consistent pro-growth policies and clear communication will be essential to maintain momentum.

Regarding policy actions by Prabowo, what are the key sources of concern?

Market sentiment has soured due to unclear communications from Prabowo's administration, contrasting with the cohesive policy execution under Jokowi. Despite initial concerns over the military law and Danantara, the appointment of competent technocrats, not military figures, to Danantara has been reassuring.

While the expansion of military roles in government has raised fears of a return to a Soeharto-style dual role military government, the current administration has only slightly increased military posts, focused on defence and security, maintaining a separation from government.

However, further military integration could negatively impact the market. Prabowo has seemingly taken heed of market reactions, recognising that a heavy military influence could jeopardise Indonesia's future and foreign investment, perpetuating its reliance on commodities.

Investor worries about military overreach and oversight at Danantara contributed to the market's recent decline. Yet, the unveiling of a diverse, experienced Danantara board suggests effective governance. The market, currently undervalued, witnessed a rebound as opportunistic investors engaged in short-term buying. Clarity on Prabowo's policies geared towards domestic consumption will be the next focus for investors.

Despite domestic challenges, Indonesia maintains a BBB credit rating with a stable outlook, indicating trust in its robust economic foundations, growth potential, and fiscal discipline.

What are the next catalysts for the markets, either to the up or downside?

Investors are concerned about the shift from Jokowi's infrastructure investments to Prabowo's focus on consumption. Prabowo's ‘free school lunch’ programme, while well-meaning, isn't sufficient. Indonesia must attract more foreign direct investment (FDI) to create jobs and boost wages. Although the EV battery sector has seen some investment, broader FDI is needed to maintain relevance. The country‘s economy is growing sub its potential, in marked contrast to India, which is having success in drawing FDI and investing in private and public sectors. This highlights Indonesia's policy inertia.

Populist measures, such as the free school lunch programme, are controversial in terms of quality growth. Infrastructure investment remains crucial for employment and attracting FDI. Projects like the new capital ‘Nusantara’ in Borneo are debated, with some suggesting a focus on airports, roads, and mass transit would be more beneficial. FDI is vital to balance the energy deficit, support the currency, and enhance stability.

A weaker USD could allow Bank Indonesia to cut policy rates by 75bps, aiding the domestic economy and property market. A rebound in commodities, increased FDI or public spending, rate cuts, and avoiding further military involvement in government could boost Indonesia's prospects. Q125 GDP may disappoint, leading to short-term revisions, but the microfinance non-performing loans issue should be resolved by mid-2025, reducing credit costs and potentially improving bank earnings in the second half of the year. Major blue chip banks are trading at decade-low valuations, presenting opportunities. Given banks represent 60% of the broader market, a relief there would suggest market upside.

And finally, what are the investment implications of the current political situation?

Indonesia has consistently been favoured in EM portfolios, but its small (1.2% EM benchmark) weight means its market must significantly grow to impact performance. Investors can opt for a substantial overweight if they are confident in the valuation and growth potential. Despite compelling valuations, with high-yielding stocks and a depreciated currency, questions remain about the effectiveness of Prabowo's policies and the feasibility of 5% growth². The scarcity of large cap stocks poses a liquidity challenge, making high-conviction, long-term investments crucial. If investors can’t build conviction at 1.2% of the benchmark, it begs the question as to whether they need to be invested in Indonesian equities at all.

Our EM Equity team has always liked the Indonesian equity story, and we have been overweight, like most other foreign institutional investors. This overweight has been reduced over the last 18 months and whilst we would like to see further confirmation of President Prabowo’s policies in the right direction, Indonesia's potential remains appealing due to its sizeable, young, and urbanising population, which is one of the fastest-growing consumer markets globally. With a working age population growing faster than dependents and an expected 1.6 million entrants expected into the labour market annually this decade³, Indonesia's labour force is expanding.

This demographic advantage, along with rising education and urbanisation, positions Indonesia well as it enters the middle-income category. Despite the need for job creation, the demographic dividend and the current attractive valuations keep the outlook positive.

^{1 MSCI, as at March 2025.
2 business-indonesia.org/news/prabowo-s-economic-plans.
3 Tradingeconomics.com.}