Get ready for another Asia flashpoint

Indonesian protesters who oppose the new bill on local elections chant during a noisy protest outside the parliament building in Jakarta on September 25, 2014.
Adek Berry | AFP | Getty Images
Indonesian protesters who oppose the new bill on local elections chant during a noisy protest outside the parliament building in Jakarta on September 25, 2014.

Indonesia's markets have priced in bright prospects for planned reforms, but a new law eliminating local elections has spurred concerns that the country is headed for gridlock.

"It will bring into question [President-Elect] Jokowi's ability to push through the desired reforms after he takes his oath of office on October 20," Kanal Kumar Kundu, an analyst at Societe Generale, said in a note this week.

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Last Friday, Indonesia's opposition-controlled parliament passed a bill scrapping direct elections of local officials and instead giving elected regional councils the power to appoint mayors and governors. The move, which was essentially the outgoing parliament's last hurrah, would likely prevent outsiders such as Jokowi, whose full name is Joko Widodo and got his start as mayor of Jakarta, from ever taking political office. Some analysts expressed concern that the new incoming parliament will go a step further and amend the constitution to end direct presidential elections.

Kundu expects that the coalition of Prabowo Subianto, the losing presidential candidate and ex-son-in-law of former dictator Suharto, will use its control of 31 of the 34 provincial legislatures to dominate the country.

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Why Indonesia needs to cut fuel subsidies   

"This will not only deal a body blow to the confidence of the foreign investors who were banking on Jokowi coming to power (as against Subianto) during the presidential election, but will also pose a serious threat to the economy's ability to grow at 6 percent and beyond, which at one point in time was thought of as a mere formality," Kundu said.

Jokowi has inherited an economy that is in urgent need of reforms to put it on a sustainable growth path, including cutting fuel subsidies to free up cash for sorely-needed infrastructure investment.

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"By removing the local elections, it probably makes reforms harder going forward as the new local administrators are likely to push back against the government's reform agenda," Fred Gibson, an economist at Moody's Analytics, said, although he noted that subsidy and infrastructure reforms may still manage to pass.

Investors have reacted negatively, with the Jakarta Composite Index shedding 1.3 percent the day the bill passed. It fell another 2.7 percent on Thursday after Prabowo's coalition won the election to lead parliament, for a cumulative 3.9 percent decline since last Friday. The rupiah has lost as much as 2 percent of its value against the dollar since last Friday.

Rolling back democratic election may not hurt the economy much by itself, some analysts noted.

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"While the market has reacted negatively to the news, it is unlikely to be due to the direct economic impact from the scrapping of regional elections – which is largely minimal," said Wellian Wiranto, an economist at OCBC, in a note Monday.

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What next for Indonesia?   

"It is reacting more to the realization that same opposition parties which controlled enough of the outgoing parliament to push through this law will still be retaining control of the incoming one – and they have proven themselves ready in trying to make sure that Jokowi's presidency will not be a smooth one," he said.

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Wiranto expects the Jokowi will need to offer up cabinet seats to some of the opposition parties, rather than seeking "technocratic professionals." But the alternative is a much bigger market risk of a "zealously antagonistic legislature," Wiranto said.

Indeed, rolling back elections is enough of a harbinger that Deutsche Bank shifted from saying in a note last week that it was positive on Indonesia's market to qualifying it this week that the bank would need to see a credible and capable cabinet and a "bold" fuel price increase before it could remain a buyer.

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Citigroup expects the size of the hike will be limited as a larger one would need to include additional allocations for the poor, a move that would need parliamentary approval. The bank remains cautiously optimistic on the market, expecting the election law could be eventually overturned by the Constitutional Court, while crucial short-term reforms such as a new land acquisition law and civil servant reform may proceed.

Others are more blunt about what may lie ahead for Indonesia: "The baseline scenario that is shaping up is political gridlock," said Tim Condon, head of research for Asia at ING, in a note earlier this week.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1