ADDED LIQUIDITY:

Despite its current status as one of global investors’ market darlings, Indonesia’s capital markets still require development. One of the important current issues is a lack of liquidity – the market term describing the ease of buying and selling securities without dramatically influencing their prices in the process. Liquidity provides investors the comfort they need to focus on macroeconomics and company outlooks.

Offering a liquid market means, in most cases, volume: a long list of stocks and bonds to trade in, enough investors to ensure that whether for small shares or large blocks, buyers and sellers that can easily find each other, and institutional investors to hold large blocks of shares in the market’s safer bets, to add price stability.

Indonesia is working on a host of reforms that could help boost liquidity, such as encouraging companies to sell shares on the market and increase their corporate bond offerings (see overview). One significant event that took place in 2011 was the classification of its sovereign debt as investment grade by Fitch, the global ratings agency. In its announcement, Fitch said that it was raising the rating from BB+ to BBB-, citing steady economic growth, declining debt and general macroeconomic stability.

An upgrade was widely expected. Indeed, in mid-2011, Baradita Katoppo, Fitch’s country director for Indonesia, told OBG that his agency’s upgrading of the outlook for Indonesia to positive in February 2011 signalled that a review and potential upgrade were likely within 12 to 18 months. The country’s government bonds are currently rated one notch below investment grade by Moody’s and Standard & Poor’s, but these two agencies are widely expected to follow suit and award an upgrade in 2012.

In terms of aiding the market, the increased rating will draw attention and additional investors, as the positive sentiment reinforces Indonesia’s current investment thesis that consumer-driven growth will keep the economy growing at a high rate. The ratings upgrade could also provide a significant boost to liquidity for the market because it could create a sudden increase in the number of potential buyers of government bonds. Mutual funds and other structured investment vehicles have rules for investing, and in many cases these rules stipulate that any bonds must be rated investment grade.

That might not be enough for Indonesian funds.

Many of the country’s big institutional investors, such as its pension funds and insurance companies, often require bonds at an A rating or above, which is two notches higher. It would take a regulatory change in some cases to allow funds to buy bonds rated lower than A, but even still, bonds have competition from the high-yield, short-term time deposits that banks have on offer. This has unwanted effects for the bond market. “That constrains the development of the capital market,’’ Katoppo said. “The banks offer much more attractive and flexible debt alternatives. If the relevant regulators are willing to reduce the investment threshold from A to BBB, that would really help develop the local bond market.’’ Before the ratings agencies provide the upgrade, they are looking for reassurance on a few key issues termed Indonesia’s structural weaknesses, such as its infrastructure bottlenecks, concerns about inflation, foreign-investor sentiment and corruption.