(This June 8 story has been corrected to say that Indonesia runs a small budget deficit, not a surplus, in paragraph 9)
By Stefanno Sulaiman and Rae Wee
JAKARTA/SINGAPORE (Reuters) - Indonesia's President-elect Prabowo Subianto wants to give school children free meals, but the plan and his pledge to be 'daring' on spending have the country's debt and currency markets on edge.
Prabowo and his team have tried to distance themselves from any suggestions of fiscal profligacy, and to assure market participants the incoming government respects the legal debt limits that cap its budget deficit at 3% of economic output.
But for a market just getting accustomed to stability and recognition for fiscal prudence under current Finance Minister Sri Mulyani Indrawati, the mere suggestion of heavy spending has been unsettling.
Bond yields have risen and the rupiah has depreciated, though the currency weakness has largely been due to a resilient U.S. dollar.
"Our base case remains that this is more of noise at the moment, but we do see increasing fiscal risk and hence the market may start to require more risk premium on Indonesian government bonds," said Jenny Zeng, chief investment officer for APAC fixed income at Allianz (ETR:ALVG) Global Investors.
"Also another risk is because there’s a change of ministers," Zeng said, referring to uncertainties about who will step into the shoes of the highly acclaimed ex-World Bank managing director Sri Mulyani.
A banker at a Chinese lender in Indonesia said the fiscal concerns had prompted it to move around 30% of its portfolio into lower-tenor instruments, including diversifying into rupiah-denominated short-term securities (SRBI) issued by Bank Indonesia.
Prabowo won the election in February, but takes office only in October. His free-meal plan, which his team estimates will cost 71 trillion rupiah ($4.35 billion) in 2025, should ordinarily not cause any consternation.
Southeast Asia's biggest country has seen its finances improve under the Jokowi administration and runs a small budget deficit. From being rated junk at the start of the century, its bonds are now regarded as investment grade.
Some investors even see merit in Indonesia spending more to achieve its 8% economic growth target. Yet there's unease over how much money Prabowo intends to spend on his programmes, and whether he will cut fuel and other subsidies and investments in order to balance the books.
"It appears there will be more uncertainties than certainty. I still stay invested but probably not as overweight as I used to be," said Clifford Lau, a portfolio manager at William Blair.
Foreign portfolio investments have been shrinking, with overseas investors pulling $2.8 billion from rupiah government bonds and its stock market until June this year.
The rupiah is at four-year lows against the dollar, with losses of more than 5% this year, although most of that has been in line with the broad decline in emerging market currencies owing to rising U.S. yields and a rising dollar.
Investors seeking higher yielding bonds have also been switching to India, whose bonds not only have comparable yields but have also just made it into JP Morgan's global index.
The selling has sent yields on Indonesia's 10-year bonds up 35 basis points since late May, to 7.05%.
IT'S NOT ALL BAD
Some investors are giving Prabowo the benefit of doubt, pointing to how his administration also plans to increase revenues and improve tax compliance, and cap the fiscal deficit at 2.8% of GDP, even if higher than this year's 2.3% target.
"He’s also talking about the need to increase fiscal revenue ... so it’s actually not entirely about increasing expenses," abrdn's investment manager of Asia fixed income, Jerome Tay, said. Tay is overweight and positive on Indonesian government bonds in the medium term.
Those bonds have long been a favourite among emerging market investors for their 'carry' or high yield.
The spread between Indonesian and U.S. bond yields is currently half the 600 basis points it used to be before the Federal Reserve started raising rates in 2022, nonetheless they are still attractive for fixed income investors.
The country is also now less vulnerable, given foreign holdings account for only 14% of outstanding government bonds. They used to own half the bonds a decade ago.
Expectations that the Fed will soon begin cutting rates is of some comfort to rupiah and Indonesian bond investors, Rudiyanto, a director at local asset management Panin said.
But other risks loom, notably huge debt maturities at around 800 trillion rupiah in 2025, nearly double that this year, although Sri Mulyani has said refinancing will not be a problem, provided the government maintains market confidence.
($1 = 16,335.0000 rupiah)