Signs of another flight to safety by emerging markets investors are shining a spotlight on Indonesia’s efforts to localise its rupiah bond market.

The administration of President Joko Widodo believes getting Indonesians to own more rupiah-denominated issuance would shield the country’s financial system from getting whipsawed each time the global herd panics.

But the government’s time would be better spent on making Indonesia more friendly to foreign direct investment — including overhauling the country’s overly rigid labour laws — than tackling the considerable challenge of getting more of its countrymen to buy Indonesian.

There is consensus that the rupiah would be less prone to sharp swings in capital flows if there were a rebalancing of ownership away from foreign investors who, as of June, owned 39 per cent of the $179bn local currency bond market.

This is one of the highest rates in Asia, and research has associated increased bond ownership by domestic investors with lower and more stable yields. The government certainly believes this. Finance minister Sri Mulyani Indrawati said she wanted soon to see the ratio of foreign owners fall to 20 per cent, pinning her hopes on the appetite for investment in securities among Indonesia’s expanding middle class.

But this is wishful thinking, especially given that the struggling economy limits the ability of the average Indonesian to increase their savings. This ratio is unlikely to shift in the near term — despite widespread global jitters, Indonesia’s relatively high yields are a big draw for emerging market investors.

Instead, the government should be safeguarding the rupiah by pursing reforms to attract more foreign direct investment, which tends to be stickier than portfolio inflows.

While the timing is ripe as companies move out of tariff-hit China, the politics involved in tackling Indonesia’s labour laws are daunting.

Managing the swing

After last year’s efforts to defend a slumping exchange rate — including a cumulative 175 basis points in rate rises — policy has shifted with the US Federal Reserve, allowing the Indonesian central bank to focus more on growth. This was confirmed with last month’s unexpected 25bp rate cut, the second this year.

The rupiah is likely to remain under pressure so long as Indonesia and other emerging markets face headwinds such as falling exports and slowing growth in the face of the US-China trade war and a decelerating Chinese economy.

Another pressure point is brewing as a three-year lock-up period on funds repatriated under a tax amnesty programme is due to expire in October. The programme, held from September 2016 to March 2017, managed to collect Rp147tn ($10.3bn) previously kept overseas by Indonesian citizens. This is not a small amount: quarterly portfolio inflows have averaged $4.4bn over the past three years.

Diaspora to the rescue?

To encourage domestic bond ownership, the government has floated the idea of issuing “diaspora bonds” for the 8m Indonesians living overseas. These could be similar to Indonesian retail bonds though, if their take-up is any guide, they will have only a marginal impact on overall bond market ownership. Indonesian retail investors control less than 3 per cent of total government securities, a rate that has barely changed since 2013, when data first became available.

The banks are the biggest government bondholders, but their share of ownership has dropped to 23 per cent from 34 per cent since 2013. While this suggests that banks are disbursing more loans to the real economy, it also indicates some weakness in the appetite and capacity of average Indonesians to save amid the challenges facing the economy. Annual household savings growth has consistently weakened over the past five years.

Loosen the rules

Instead of being fixated on the ratio of foreign ownership, the government should be paying more attention to FDI inflows. Mr Widodo has made some progress in making Indonesia more open to business. The country’s ranking in the World Bank’s Ease of Doing Business jumped to 72nd in 2018 from 114th in 2014 but has dropped to 73rd this year, suggesting that reform is stalling.

“If Indonesia can find a way to open up its economy to foreign direct investment, this would reduce the dependence on portfolio inflows and reduce the risk to the financing of the current account deficit,” said Jon Harrison, managing director for EM macro strategy at TS Lombard.

Labour productivity remains a big obstacle to investment and economic growth. The coal export boom ended in 2012 and labour productivity growth dropped to 2.6 per cent last year from 5.6 per cent in 2013 as jobs growth slowed and labour underutilisation rates rose.

Low productivity reflects a rigid labour law. Companies in Indonesia are forced to rely on contract workers because they are restricted from firing employees without a criminal case and must provide generous severance packages.

The government has been trying to reform hire and fire since the aftermath of the Asian financial crisis but has been stymied by labour activists.

Shortly after winning re-election in April, Mr Widodo, who is popularly known as Jokowi, said he had “nothing to lose” in his second term, pledging to lower corporate taxes, overhaul the labour law and lift foreign ownership restrictions. However, delays to announcements of new cabinet members, which were meant to demonstrate his commitment to reform, indicate that he is still vulnerable to political pushback.

An economic adviser to the president said a bill to review the labour law would be submitted to the House of Representatives after his cabinet is formed, but analysts are not hopeful.

Resistance to change is stiff, the House has a poor record at passing legislation and, with the Papua Autonomy Law expiring in 2021 and plans to move Indonesia’s capital, Jokowi has other things on his mind.

“I think it’s going to be hard for the government to push for a labour law revision,” said Arya Fernandes, an analyst with the Center for Strategic and International Studies in Jakarta.

— Andi Haswidi, Head of Asean Research, FT Confidential Research

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and south-east Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.