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Indonesia is latest emerging market whipping boy

Sha Ying | CNBC

Indonesia's benchmark stock index dropped 5.6 percent on Monday to its lowest levels since January this year.

The index posted its worst one day loss since September 2011 and the rupiah weakened to a more than four-year low, trading at around 10,495 to the dollar.

Among the cocktail of factors weighing on the market was a decision by Indonesia's central bank to raise the reserve requirements for the country's banks as well as outflows from emerging markets on concerns the U.S. Federal Reserve is preparing to taper its bond buying.

(Read more: Emerging market taper terror 'quite overdone': Mobius)

By itself, the reserve requirement increase would drain a "quite substantial" $5 billion from the market, said Herald Van Der Linde, head of Asia-Pacific equity strategy at HSBC.

"Inflation is a big issue because Indonesia allowed fuel prices to increase. They need to try to control the liquidity to avoid inflation moving substantially higher," he said. The country is also more dependent than some of the region's other markets on inflows, with significant investments from foreign investors in the country, he noted.

Indonesia's central bank also reported Friday that the country's current account deficit widened to 4.4 percent of gross domestic product in the second quarter of the year, from 2.4 percent in the previous quarter. After spending much of the summer intervening to support the rupiah above 10,000, the currency has lost a prop as Indonesia's policymakers say the currency's weakness isn't really a concern.

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"When it rains, it floods," said Song Seng Wun, head of research at CIMB. "There's not much they can really do. It's just tinkering around the margins when the tide is really against them."

"The lesson from the financial crisis from a few years ago is you can't fight the market."

The drops in Indonesia's currency and stocks may not be done. "If there is no policy response, Indonesia's markets will continue to fall," said Sanjay Mathur, head of non-Japan Asia research strategy at RBS, noting that he expects the rupiah to trade closer to 11,000 against the dollar by end-September.

"They should raise rates immediately," Mathur said. "It would certainly help in stabilizing the currency and shifting the negative sentiment."

(Read more: What's really holding back growth in India)

Even with the latest drop, the rupiah still looks a little overvalued, HSBC's Van Der Linde said. He believes the equity market is now fairly priced.

"The Indonesian market is actually a little more expensive than other markets in the region. But it should also be because it's more profitable," Van Der Linde said, adding it could fall "a couple percent" before it gets really cheap.

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