Indonesia Stocks Tank as Frontier‑Market Threat Looms

Indonesian stocks have taken an index-induced haymaker to the chin over the course of the last two days.

What started the worst selloff for the Jakarta market since the Asian financial crisis in 1998?

A warning from index provider MSCI. The bottom line: MSCI could downgrade Indonesia from emerging-market status to a frontier market.

That would force a massive reallocation by institutional investors, and demand an adjustment from anyone running an index-tracking or index-benchmarked product.

Indonesia has been an emerging market ever since MSCI unveiled the MSCI Indonesia Index in 1990. A downgrade to frontier status would put it in the same category as the likes of Vietnam, Sri Lanka and Pakistan, typically tiny markets that are highly volatile.

What’s Prompted the Move?

Why has MSCI come to this decision?

The company has just completed a review of the free float available for Indonesian stocks. It says “many investors” have complained about the opaque nature of the Jakarta market.

Investors are concerned that the data generated by the central stock depository, the Kustodian Sentral Efek Indonesia, to categorize shareholders as potential company insiders miss shareholding structures designed to skirt the insider-trading rules, potentially also leading to “coordinated trading behaviour that undermines proper price formation.”

In other words, controlling families may use complex holding structures to mask how much of a company they own, and in particular how much of a company’s equity and voting power they control.

Such potential shadow control of a company via a holding-company structure is a common problem in Asia, causing a reduction in the true free float of a stock. But investor concerns grew loud enough in Indonesia to force a recalibration by the index provider.

You can read the full text of the MSCI ruling here.

Frozen Index Changes

MSCI has temporarily frozen some index changes for Indonesian securities. It won’t, for instance, add new companies to indexes for the time being, or reclassify companies from, as an example, small-cap to standard.

MSCI has given Indonesian regulators, the central depository, and the Indonesia Stock Exchange, known locally as the Bursa Efek Indonesia, until May to improve transparency in the Jakarta market.

If the index provider doesn’t see improvement, it could downgrade Indonesia to a frontier market, and/or reduce the weighting of Indonesian stocks in any emerging-markets index.

MSCI delivered the warning after the close of trade in Indonesia on Tuesday. Investors immediately responded with heavy selling over the course of Wednesday and Thursday.

Intense Market Response

The IDX Composite, the index tracking the Indonesia Stock Exchange, fell 16.5% between Tuesday’s close and 10 a.m. local time on Thursday. The stock market has paused trading for 30 minutes both Wednesday and Thursday. That’s after circuit breakers kicked in to halt trading when stocks slip more than 8.0%.

The Jakarta market recovered in late trade Thursday. It ended the day down 8.2% from Tuesday’s close.

The selloff has wiped about US$80 billion off Jakarta stocks. To make matters worse, Goldman Sachs  (GS)  Thursday lowered its rating on Indonesian equities to “underweight.” GS also estimates that a downgrade to frontier status could result in forced foreign investor outflows of US$7.8 billion.

But international investors aren’t hanging around to find out. They’re selling on the warning rather than waiting around to find out if MSCI follows through.

Changes Likely but Will They Be Enough?

Some market watchers predict that the Indonesian authorities will make just enough changes to avert a reclassification. The Indonesian financial authorities on Thursday said the government accepts the index provider’s views as “good input.”

Indonesian regulators say they’ve had positive communication with MSCI, and intend to double the required free float on Indonesian stocks to 15%.

A handful of extremely wealthy families control the Indonesian economy. The same situation applies in other Southeast Asian nations, but Indonesia is now under the governance of President Prabowo Subianto, a deep insider who remains the son-in-law of late dictator Suharto, even though he is technically separated from his wife.

Prabowo this month put forward his nephew, Thomas Djiwandono, as deputy governor of the central bank. The move caused a plunge in the Indonesian currency, the rupiah. The currency is near the record-low levels prompted by the 1998 Asian financial crisis.

We can watch to see if MSCI backs off its threat to downgrade Indonesia. But concerns about Prabowo’s governance and potential insider dealing among Indonesian companies will continue unless the financial authorities make significant changes that would be unpopular with the ruling elite.