Meanwhile, the ratings are constrained by (i) uncertainty underlying the coalition government's capability to formulate and implement policies, (ii) entrenched structural issues pertaining to the investment and business environment such as inadequate infrastructure, legal system and financial intermediary functions, which may hinder further growth acceleration, (iii) underdeveloped export-oriented manufacturing industry stemming from the country's endowments such as affluent natural resources, over 230 million population and archipelago consisting of more than 17,000 islands and (iv) volatile cross-border capital flows under a free and open capital account system.

The rating outlook is "stable." JCR believes that Indonesia will, by and large, sustain modest economic growth while maintaining macroeconomic stability and fiscal soundness in the years to come. In order to further enhance its resilience to the unpredictable external environment such as commodities prices and the world financial and economic situation, maintain or even improve its international confidence and uplift its economic growth potential, it will become imperative to enact the legal framework for a financial safety net, execute subsidy reforms and carry out structural reforms to improve the investment and business environment. This, however, should require strong political leadership and take time to materialize.

(1) Coalition government's policy making and implementing capability to be tested
Bold democratization and decentralization initiatives since the post-Suharto era are now taking root in Indonesia. In October 2009, the second Yudhoyono government took office following the general and the presidential elections. Although President Yudhoyono gained 61% of the votes in the presidential election, his party, the Democratic Party, took only 27% of the parliamentary seats, making it inevitable to count on cooperation from other coalition partners.

Under such circumstances, a rift among the coalition parties surfaced from the end of 2009 over the government's capital injection in November 2008 to rescue the then ailing Bank Century, which eventually led to the resignation of the reformist finance minister. In June 2010, a proposal was made in parliament to distribute what might be regarded as pork-barrel funds to the electoral constituencies, a step seen to reverse the reform initiatives. As such, there still remain uncertainties over whether timely and effective policies are formulated and implemented to maintain the international confidence and accelerate economic growth under the current coalition government which is to last at least until 2014.

(2) Moderate economic growth to be sustained. Addressing structural issues to accelerate growth poses challenges
Indonesia has been posting steady economic growth for over the last 10 years, mainly led by domestic demand. It even maintained 4-5% positive growth rates even between the fourth quarter of 2008 and the first half of 2009 when many of its neighboring Asian countries underwent negative growth hard hit by the global economic crisis that originated in the United States. Indonesia, embracing the world's fourth-biggest population and with more than USD2,000 per capita GDP where rising purchasing power is further boosting consumption, is projected to sustain moderate economic growth in the years ahead, driven by robust domestic demand centering on private consumption.

In order, however, to accelerate the growth further, it would be critical for the country to address its entrenched structural issues such as developing its infrastructure (e.g., power and logistics), improving the legislations to facilitate both domestic and foreign investment, securing legal certainties and deepening its financial intermediary functions. Furthermore, Indonesia has been rather slack in fostering export-oriented manufacturing industries that constitute manufacturing industries' production and distribution network in East Asia as evident in many of its neighboring countries, due in part to its endowments such as affluent natural resources, more than 230 million population and archipelago consisting of more than 17,000 islands. This may have led to the recent decline in the share of non-oil and gas manufacturing industries in GDP. The second Yudhoyono government has identified the improvement of the investment/business environment infrastructure, energy, and bureaucracy reforms and governance as the national priorities and put policies and frameworks in place to address them. It is hoped that timely and effective progress will be made on those structural issues.

(3) Sound fiscal position and alleviated public debt burden. Subsidy reforms seen as litmus test
Indonesia's fiscal position, which deteriorated at the time of the Asian crisis, has improved substantially in recent years, thanks to its prudent fiscal management backed by the fiscal disciplinary framework as stipulated in the State Finance Law. The fiscal debt burden has been largely alleviated as seen in the level of the central government debt standing at 28% of GDP at the end of 2009 and the ratio of interest payment to the total expenditure at 10% in fiscal 2009. Fiscal financing is made mainly through domestic bond issuance, around 80% of which is held by domestic investors such as banks, insurance companies, pension and mutual funds. The ratio of outstanding government bonds to money supply (M2) has also been reduced significantly, which enables the domestic market to absorb the government bonds stably.

The government has set a medium-term fiscal framework, envisaging the contraction of budget deficit from 2.1% of GDP in fiscal 2010 to 1.1% in fiscal 2014. In achieving this, the fuel and electricity subsidies, which still weigh heavy on the public finances accounting for 18% of the revised budget for fiscal 2010, could increase further, depending upon international oil prices, domestic oil production and domestic fuel consumption. To reduce such burden, the government raised a part of the electricity tariffs in July 2010 and now plans to set some sort of ceiling on the supply of subsidized fuel. The net impact of rises in oil prices per se could be limited as it also increases the oil-related revenues. That said, subsidy reforms are seen as a touchstone of the government's will and capability to carry out overall reforms and need to be carefully watched.

(4) Expanding nonresidents' portfolio inflows/outflows. International confidence becomes important
Indonesia, retaining a free and open capital account and sustaining steady economic growth, has attracted a larger volume of cross-border portfolio investment inflows in recent years, which in turn has magnified volatility in capital inflows/outflows. Nonresidents' inward portfolio investment in the BOP statistics registered USD4.0 billion in net outflow in the fourth quarter of 2008 (subsequent to the Lehman shock), USD10.3 billion in net inflow in 2009 and USD6.6 billion in net inflow in the first quarter of 2010. Investments in the government bonds and central banks' short-term paper (SBI) accounted for the bulk of such capital inflows. In May 2010 when Europe underwent credit woes, the nonresidents' holding of SBI, a highly liquid instrument, fell by IDR47 trillion (approximately USD5.1 billion).

The authorities have been basically dealing with such volatile capital flows through foreign exchange market intervention using its foreign reserves. Thanks to the large capital inflows, the foreign reserves (excl. gold) rose from USD49.6 billion at the end of 2008 to USD75.8 billion at the end of April 2010. Moreover, Indonesia's private external debt has added to stability, with 50% of the total borrowing made by foreign and joint venture companies and 32% of the total lending provided by parent and affiliated companies at the end of 2009, respectively. These indicate that Indonesia has been improving its resilience to external shocks. In fact, a recurrence of the Asian crisis, in which capital outflows triggered currency, financial and economic crises, was staved off when the country experienced the sharp capital outflows in the fourth quarter of 2008 and May 2010. The central bank has started adopting measures to control expanding capital flows such as the announcement in June 2010 of a one-month holding period for SBI. Nevertheless, JCR holds that what matters most is to enhance its resilience to external shocks and maintain and improve international confidence by making steady progress in the legal framework for a financial safety net, and carry out subsidy and various structural reforms to improve the investment and business environment.

Issuer: Republic of Indonesia
FC (Foreign Currency Long-Term Senior Debts): BBB- (Stable) from BB+ (Stable)
LC (Local Currency Long-Term Senior Debts): BBB (Stable) from BBB- (Stable)