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Indonesia Could Face Political Turmoil Like in Egypt and Tunisia

JAKARTA LIFE'S STYLE

The political turmoil in Tunisia and Egypt is a reminder of the days when emerging markets were the Wild West of investing. While it is easy to dismiss events in those countries as unlikely to be repeated elsewhere, especially in Asian and Latin American nations with strong economic growth, investors in emerging markets are facing a much riskier landscape as a result of inflation.

The question is whether central banks and governments in many emerging-market countries are doing enough to stamp out inflation fires fueled by a combination of rising commodity prices around the globe and domestic economies operating at full tilt.

In many emerging-market countries, inflation is already running near the top of official target ranges. Indonesia and Turkey are seen at risk of falling behind in the inflation fight -- if they haven't already -- which could force much more aggressive rate increases down the road. This is especially bad news for bond investors, who see the value of their fixed-income returns eroded as inflation rises.

“We currently view overheating within the emerging-market complex as the greatest macro peril facing the global economy,“ Michael Shaoul of Oscar Gruss & Son wrote in a research note Friday.

Even before scenes of pitched battles in the streets of Egypt dominated the news, investors were growing nervous about inflation, turning tail on some markets. For the week ended Jan. 26, emerging-market stock funds experienced their biggest spell of withdrawals since the third quarter of 2008, according to EPFR. The MSCI emerging-markets index has lost 2% this year even as the Dow Jones Industrial Average is up 2%.

While most of the moves in emerging markets haven't been big, they mark a change in the outlook from 2010, when their fortunes seemed much brighter than those of struggling developed markets. Many observers are especially cautious about the near-term outlook for bonds denominated in local currencies. This had been a particularly popular investment in 2010.

With interest rates near zero in the West, investors bought higher-yielding bonds in places such as Indonesia, India and Brazil. As these economies grew, the theory went, monetary authorities would lift interest rates, which would attract even more investors, forcing up currency values and giving an added boost to returns.

It hasn't quite worked out that way. One case in point is Indonesia, which has one of the larger local-currency bond markets in Asia. Indonesia never fell into recession during the financial crisis but cut rates anyway as a preventative measure. Since then, the country hasn't raised rates despite an economy growing 6% and inflation that hit nearly 7% in December from a year earlier, well above the central bank's target.

Indonesia was an investment darling last year. Foreign investors have funneled $9.4 billion into government bonds since the start of 2010 and now hold 30% of all government debt outstanding, compared with 15% last March. That buying helped 10-year local-currency bonds hit a low yield near 7% at the beginning of the year.

However, since then, inflation concerns have caused a punishing selloff. Foreign investors sold $1.3 billion in Indonesian bonds from Jan. 7 to Jan. 26, according to the government, taking yields on those same bonds to nearly 10%. Yields drifted back below 9% in the past few days. As yields rise, prices fall. Broadly, Indonesian local-currency bonds have lost nearly 5% of their value in just the past month, according to Barclays Capital.

“Indonesia is the one that offers the most worrisome precedent for other countries whose central banks might wind up behind the curve,“ says Michael Gavin, head of emerging-market strategy at Barclays.

In India, the rupee has dropped 4% against the dollar since early November, as food prices whip up inflation fears. The central bank has responded by restarting a campaign of interest-rate increases, including a quarter-percentage-point increase Wednesday. But that has yet to quell investors' fears. The currency fell again Friday, down 0.9%, along with stocks, which have fallen more than 10% this year, among the worst-performing markets in the world.

There are a handful of countries, such as Mexico, where many strategists feel the inflation outlook remains sanguine. But many of the problems have been caused by central banks avoiding interest-rate increases for fear of attracting even more money into their countries. Many have been intervening to keep their currencies from rising; a stronger currency can damp inflation pressures. They are also raising reserve requirements on banks and setting or increasing penalties on some investments by foreigners.

However, says Ilan Goldfajn, chief economist at Itau BBA in Sao Paulo, it is unclear if those measures will work. The result, he says, “is the additional risk that you have more of a boom-bust phenomenon where you try these measures and don't do enough . . . and then you have to tighten more at the end of the day.“

Complicating matters are the ripples from the Federal Reserve's efforts to continue pumping money into the U.S. financial system. For countries that are keeping their currencies largely pegged to the U.S. dollar, “emerging markets are in effect importing a much more lax monetary policy from the U.S. than would be suitable,“ says Natalia Gurushina, director of emerging-markets strategy at Roubini Global Economics.

Roubini Global is recommending that investors be wary of local-currency bonds, especially in Asia, for the first half of 2011, even though the firm likes the asset class as a long-term investment.
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