Investors Grow Wary of Indonesia; Protectionism, Slowing Growth Are Worries as Election Approaches

Updated August 6, 2013, 7:14 p.m. ET

Investors Grow Wary of Indonesia

Protectionism, Slowing Growth Are Worries as Election Approaches

BEN OTTO and LAUREN DAVIDSON.

JAKARTA, Indonesia—Investors are souring on Indonesia as growth slows and a contentious election approaches. Indonesia’s economy expanded by just 5.9% in the second quarter, its worst showing since 2010. Prices for commodities exports such as palm oil and coffee are down, driving the trade balance deeper into the red. Inflation hit a 4½-year high in July after the government raised fuel prices. The country’s stocks, bonds and currency, the rupiah, all have sold off this summer as investors pulled cash out of emerging markets amid speculation the Federal Reserve was preparing to wind down its bond buying. The rupiah is down 6% against the dollar since the start of May. Over the same period, yields on 10-year government debt denominated in rupiah jumped to 7.63%, from 5.5%. Yields rise when prices fall.Some investors see more trouble ahead. Indonesia is one of several emerging markets dealing with slowing growth, high inflation and a widening current-account deficit, a toxic combination for policy makers. If the rupiah continues to slide, it will make imported goods more expensive, driving up inflation and worsening the country’s finances. Higher interest rates and lending restrictions would shore up the currency, but further depress growth. Morgan Stanley MS -1.94% dubs the currencies of countries in this situation the “fragile five,” a club that also includes Brazil, Turkey, South Africa and India.

“There are concerns about policy, especially in Indonesia, about how they’re going to contain the depreciation of the exchange rate,” said Robert Abad, emerging-markets portfolio manager at Western Asset Management Co., which has about $440 billion under management. “Can the government basically step up and put certain policies in place?”

His firm cut holdings of Indonesian bonds in May. He said he is particularly concerned about Indonesian companies’ debt denominated in dollars, which becomes more expensive to pay back as the rupiah weakens.

Indonesia’s upcoming elections complicate the outlook. President Susilo Bambang Yudhoyono, who brought stability and growth to Southeast Asia’s largest economy in the past decade, is required by term limits to step down next year. With a competitive election less than a year away, policy makers are reluctant to adopt measures that could reduce growth, investors say.

“We changed our view on Indonesia’s currency about three to four months ago when we found the Indonesian current-account balance was deteriorating,” said Joon Hyuk Heo, who manages $2.4 billion as head of global fixed income at Mirae Asset Global Investments. “We were waiting for the right response from the government of Indonesia, but the response was not that impressive, so the current account balance deteriorated further.”

To be sure, Indonesia’s currency has fallen less than other members of Morgan Stanley’s fragile five, including the Turkish lira and Indian rupee. Some investors still like Indonesian bonds for their high yields.

“We’re still confident in [Indonesia’s] local currency bond,” said Keith Brakebill, who manages the $845.8 million Global Opportunistic Credit Fund at Russell Investments.

Other investors worry that Indonesia’s government is moving to restrict foreign investment in order to bolster domestic businesses ahead of the election.

The government issued a spate of protectionist rules last year, including restrictions on investing in the country’s banks.

The worry for investors is that “the country will change the game midstream,” said Chad Holm, chief executive of Yawadwipa Cos., a private-equity firm that helps to manage more than $200 million.