* Rupiah to gain further on election-fuelled capital inflows
* Rupiah remains a high-yield play despite rate cuts
* Any set-back in election may trigger rupiah sell-off
By Kevin Yao
SINGAPORE, July 7 (Reuters) - The Indonesian rupiah is likely to extend its rally and be the best performing currency in Asia this year, boosted by the country's alluringly high interest rates and the prospect of prolonged political stability.
Investors have flocked into Southeast Asia's largest economy on hopes that President Susilo Bambang Yudhoyono will win an election on Wednesday, which analysts believe will guarantee the extension of his pro-growth policy that is crucial for social stability.
Yudhoyono, who has picked former central bank chief Boediono as his vice presidential candidate, is currently leading in most opinion polls. Their win could spur foreign investment as the economy would be seen in safe hands.
"The general view is that the administration of the country in the next few years will be in safe hands," said Lim Su Sian, economist at DBS Bank in Singapore.
Indonesia's economy is one of the most resilient in Asia, along with China and India, during the global downturn because it is one of the least dependent on exports. Indonesian exports are equivalent to a third of GDP compared to 200 percent in Singapore and 100 percent Malaysia.
While Indonesia's central bank has cut policy interest rate to stave off recession, at 6.75 percent the rupiah retains a sizable yield advantage that has spurred an influx of foreign bonds into the country's stocks and bonds.
The yield on 10-year Indonesian government bonds has fallen to 11 percent from 14 percent in early March, but its spread over U.S. Treasuries is still at 7 percentage points -- among the highest in Asia.
"Indonesia's fundamental story is still pretty sound," said Thomas Harr, currency strategist at Standard Chartered Bank in Singapore.
BEST ASIAN PERFORMER
To be sure, there are risks because the rupiah and the country's markets have already surged before an expected win by Yudhoyono, who is leading the opinion poll. Any set-back could hurt investor confidence and spur profit-taking.
The rupiah is already very tied to investor risk appetite and has a very strong daily correlation with major Asian and U.S. stock markets over the past year.
The rupiah has rebounded 17 percent since the start of March, when it hit a three-month low, trailing only after the South Korean won's 24 percent jump over the same period.
The rally has turned the rupiah into the best performing currency in Asia, with a gain of almost 8 percent, from being one of the region's worst performers last year, when it lost 14 percent.
A median of forecasts by eight banks showed the rupiah should rise to 9,750 per dollar by the end of 2009, implying a 13 percent annual appreciation.
Six-month offshore forwards on the rupiah were at 10,555 versus a spot rate of 10,225, implying less depreciation than would be expected from differences in short-term interest rates.
The Indian rupee, which has also benefitted from what was seen as an investor-friendly win by the ruling Congress Party, was expected to gain nearly 7 percent this year.
For a graphic on Asian currency changes and the forecasts see http://graphics.thomsonreuters.com/079/AS_CRNCY0709.jpg
POTENTIALS VS RISKS
Indonesia's Finance Minister Sri Mulyani Indrawati forecast this week that the economy would grow 4.6 percent in the second half, accelerating from 4.1 percent in the first half.
Full-year growth in 2009 is expected to slow to 4.3 percent from last year's 6.1 percent pace as the global crisis bite, but Indonesia is an envy of its export-dependent neighbours, which are either already in or on the verge of sinking into recession.
Foreign investors have bought a net $700 million in Indonesian stocks since early March, according to Nomura.
Official data showed that foreign holdings of Indonesian government bonds increased by $900 million between end-March and June 5, but the trove had fallen by $200 million since then.
Helmi Arman, a strategist at Bank Danamon in Jakarta, argued that the bond selling was caused by broad risk aversion fanned by doubts about the global recovery, rather than Indonesian-specific concerns as sovereign CDS spreads had widened across Asia.
"Indonesia's relatively better growth prospects may still attract further inflows into the equity market and bond market inflows may also continue," Arman said in a note.
Foreign direct investment in Indonesia may top last year's tally of $17 billion despite the global turmoil, analysts say. (Editing by Eric Burroughs)