Indonesia faces day of reckoning in MSCI review

Billions of dollars hang in the balance as Indonesia faces a potential market-status downgrade that could spur another round of capital flight from the country.

The decision will be handed down by index provider MSCI, which initiated a review of Indonesia over concerns about its investability.

On Wednesday local time, MSCI will announce whether it will continue to classify Southeast Asia’s largest economy as an emerging market or downgrade it to frontier-market status.

The judgement could hardly come at a worse time. Indonesian assets have endured a bruising year marked by warnings from credit-rating agencies, MSCI peer FTSE Russell and analysts about domestic policymaking.

Geopolitical headwinds stemming from the Iran crisis have made matters worse. The rupiah is Asia’s worst-performing major currency so far this year, while its stock market has been the region’s weakest.

The Jakarta Composite Index has shed more than 30% year to date, LSEG data show, while the rupiah is down about 7% against the dollar.

The origins of investors’ disenchantment with Indonesia can be traced back to September last year, when the ouster of the country’s finance minister rattled foreign observers who had viewed her as an anchor of fiscal stability.

A series of policy moves by the Prabowo Subianto administration, including a multibillion-dollar “free lunch” program and the appointment of the president’s nephew to central bank, have done little to win investors over.

When MSCI first flagged transparency issues in January, it sparked a nearly $80 billion market rout in Indonesia. Ballooning subsidies to help consumers and businesses cope with the energy shock from the Middle East war have only added to concerns that fiscal consolidation would go completely off the rails.

Still, stock-market regulators have moved quickly to address the concerns raised by the index providers, and Indonesia has likely avoided a downgrade for now.

“My base case is in line with probably most market participants’: that Indonesia will retain its status as an emerging market,” said Christopher Leow, chief executive of Principal Asset Management, Singapore.

Analysts at Gavekal Research note that when MSCI lowered Indonesia’s information-criterion assessment to negative last week, citing “limited transparency in shareholding structures,” it did not foreshadow a harsher penalty.

Keeping the emerging-market status it has held since 1989 is critical for Indonesia, where foreign investors own an estimated 37% of local equities, said Gavekal’s Tom Miller and Udith Sikand.

Kevin Khaw Khai Sheng, assistant manager of research at iFast Capital, also thinks Indonesia will manage a lucky escape from an adverse ruling that would spark a fresh wave of index-driven redemptions that it is no position to absorb.

Regardless of the outcome, however, the broader backdrop remains grim, Khaw added, citing a deepening policy-credibility crisis, a rupiah pinned near record lows and a trade surplus that has all but evaporated, forcing Bank Indonesia into pro-cyclical tightening.

Absent a drastic shift in policymaking that restores Indonesia’s reputation abroad, more pain could lie ahead.

“Staying in the emerging-market index will keep Indonesian stocks in global investment mandates, preventing a further wave of foreign capital outflows and providing a much-needed confidence boost,” Gavekal’s Miller and Sikand said.

“But the recovery could prove short-lived if policymakers do not change tack at home.”

Write to Fabiana Negrin Ochoa at fabiana.negrinochoa@wsj.com and Ying Xian Wong at yingxian.wong@wsj.com