Why is Indonesia facing a rare MSCI downgrade and what's at stake?

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SINGAPORE: About US$65 billion was wiped off the value of Indonesian stocks on Oct 16 after global index provider MSCI proposed downgrading the country's stock market from emerging market to "standalone" status.

The Jakarta Composite plunged 11.6 per cent following the announcement, marking its biggest one-day fall since the 1998 Asian financial crisis.

The proposal caught investors by surprise, as it went further than MSCI’s initial warning in January that Indonesia could be demoted to “frontier market” status.

If implemented, the downgrade could trigger billions of dollars in foreign outflows from Southeast Asia's largest economy, even as Indonesian authorities pursue reforms aimed at addressing concerns over market transparency and trading practices.

But the downgrade is not yet a done deal. MSCI has given Indonesia time to demonstrate meaningful and lasting improvements before reaching a final decision next year.

What does a standalone status mean, why is MSCI considering such a drastic downgrade, and how could it affect Indonesia’s stock market? 

THE INFLUENCE OF MSCI

MSCI, originally known as Morgan Stanley Capital International, is one of the world's largest index providers, alongside rivals such as FTSE Russell and S&P Dow Jones Indices. 

Its influence lies in the widespread use of its benchmarks by global fund managers, who rely on them to guide investment allocations and measure the performance of their portfolios.

About US$10 trillion in assets are benchmarked against MSCI's Emerging Markets Index, making its decisions on which countries and companies to include potentially consequential for investment flows.

A country's inclusion in or exclusion from these indexes can therefore influence how much foreign capital enters or leaves its stock market.

WHAT A STANDALONE DOWNGRADE MEANS

MSCI classifies global equity markets into four categories: developed, emerging, frontier or standalone.

Frontier markets are smaller, less developed or less accessible than emerging markets.

To qualify, a market must have at least one company meeting MSCI’s minimum size and liquidity requirements, among other criteria, and demonstrate a degree of accessibility to foreign investors

Asian markets in this category include Vietnam, Pakistan, Sri Lanka and Bangladesh. 

Standalone markets, meanwhile, sit outside MSCI’s developed, emerging and frontier market indexes. 

They are broadly classified into two groups: newly eligible markets and markets previously classified under the developed, emerging or frontier market categories.

According to MSCI, a market may be reclassified as standalone if there is a severe deterioration in its accessibility, size or liquidity.

Markets in this category include Argentina, Lebanon, Nigeria and Ukraine. None are in the Asia-Pacific region.

For Indonesia, a downgrade from emerging to standalone status would mean its stocks being removed from major emerging market indexes tracked by investment funds worldwide.

Funds that passively track these indexes, or are ranked against them, would be forced to sell their Indonesian holdings. Actively managed funds benchmarked against them could also reduce their exposure.

If Indonesia’s market is downgraded to standalone status, it would become the largest economy in the standalone category, at more than twice the size of Argentina, the next largest.

CONCERNS OVER TRANSPARENCY AND MARKET FUNCTIONING

MSCI's concerns go beyond the size and liquidity of Indonesia's stock market to more fundamental questions about how it operates, analysts told CNA.

Allspring Global Investments' portfolio manager Gary Tan said the index provider's core concerns centre on Indonesia's market transparency, price formation and the credibility of regulatory enforcement.

Similarly, Eastspring Investments said MSCI's proposed downgrade reflects questions about the integrity and credibility of Indonesia's trading mechanisms.

In January, MSCI first warned that Indonesia could lose its emerging market status, citing opaque share ownership structures, suspected coordinated trading activity and inadequate enforcement.

It said its clients had flagged concerns about the reliability of market data, particularly information on the proportion of shares available for public trading, known as free float, and how shareholders were classified.

These made it difficult for investors to determine how many shares were genuinely available for trading.

Concerns that some stock prices may have been artificially supported also raised questions about the reliability of market prices and the effectiveness of regulatory oversight, MSCI said.

Indonesian officials, however, have questioned the basis of MSCI's assessment and called for greater transparency over its methodology.

President Prabowo Subianto told his Cabinet earlier this week that the global index provider was trying to "intimidate" the country.

Hanif Dhakiri of the National Awakening Party, who sits on the parliamentary committee overseeing finance affairs, called for MSCI's methodology to be transparent, objective and consistently applied across countries.

"We should not be defensive in the face of criticism, but neither should we accept judgements without examining their basis and objectivity," he told Reuters.  

MSCI, in an emailed response to Reuters, said its decisions follow transparent and rules-based methodologies.

WHY MSCI IS CONSIDERING A MORE SEVERE DOWNGRADE 

Last week, MSCI went a step further, saying that demoting Indonesia’s market to frontier status might not adequately reflect the severity of these problems.

The global index provider said Indonesian authorities had failed to make “sufficient progress” in demonstrating consistent implementation of market reforms and their sustained impact.

Weak enforcement also remained a concern, it added.

Mr Tan said MSCI may be concerned that downgrading Indonesia to a frontier market instead of a standalone status would simply transfer its unresolved underlying market issues into another MSCI index.

"This would be more disruptive, as Indonesia would leave (the emerging market index) without the offsetting inflows from frontier index funds," he added.

Angus Mackintosh, an ASEAN specialist at Aletheia Capital, suggested that MSCI's earlier removal of several Indonesian companies from its Indonesia index may also have influenced the severity of its latest proposal.

"This may have had a bearing on the severe approach this time around," he told CNA.

"MSCI has already made it clear that it will downgrade Indonesia unless it makes progress on its demands to sanction market abuse, although it has not been specific as to what it wants."

Following MSCI's proposal, Indonesia's Financial Services Authority disclosed fines of millions of dollars for market participants involved in trading violations - including three of the companies MSCI had cut from its index.

BILLIONS OF DOLLARS IN POTENTIAL OUTFLOWS

A downgrade could trigger billions of US dollars in capital outflows as international funds sell Indonesian equities to align their portfolios with MSCI's revised classifications.

Indonesia has been classified as an MSCI emerging market since 1989. 

Losing that status would mark a significant change for a market that was, until recently, a favourite among foreign investors.

The impact would be quite severe in terms of passive money outflows and active money outflows, Mr Mackintosh said. 

Banks estimate that a downgrade could trigger US$3 billion to US$6 billion in outflows from passive emerging market funds.

UBS also warned that active investors could withdraw another US$15 billion. 

Beyond the immediate selling pressure, a downgrade could affect how international investors assess Indonesian assets.

It could impact Indonesia's currency negatively and increase the cost of capital in the country, Mr Mackintosh said. 

However, Eastspring Investments cautioned that the eventual impact would depend on the index providers’ final decisions, how any reclassification is implemented and how investors respond to Indonesia's ongoing capital market reforms.

The projected outflows are also estimates rather than guaranteed withdrawals, with actual selling likely to depend on the composition of investment portfolios and the timing of any index changes.

In the near term, uncertainty surrounding this reclassification review may prolong volatility in Indonesian equities, particularly amid limited domestic catalysts and persistent external pressures, it said.

The market could face a prolonged period of uncertainty over the next six to nine months, until MSCI reaches its final decision before June next year, Eastspring Investments added.

A WINDOW TO AVERT A DOWNGRADE

Analysts said Indonesia still has an opportunity to retain its emerging market status, but will need to demonstrate that its reforms are producing lasting improvements in market conduct and transparency.

MSCI has given the country time to address the concerns raised by investors and demonstrate that its reforms are delivering lasting improvements in market transparency, conduct and enforcement.

The index provider is consulting institutional investors until next April, with a final decision expected by June.

Macquarie Group's head of ASEAN equity research Jayden Vantarakis told CNA that regulators must take sufficient action to address concerns over market conduct and convince institutional investors to oppose the proposed reclassification.

Similarly, Mr Tan said Indonesia must demonstrate tangible improvements in transparency, trading practices and enforcement.

"Ultimately, MSCI will need confidence that these measures will remain effective after the current index freeze is lifted," Mr Tan explained. 

Indonesian authorities have already introduced a series of measures since MSCI first raised its concerns in January. 

Top officials were replaced by figures widely known and trusted by markets. Its financial regulator and stock exchange introduced tighter measures and adopted reforms intended to reduce the risk of market manipulation. 

Hours after MSCI’s latest announcement, Indonesia’s financial regulator also imposed a total of 2.1 trillion rupiah (US$116.41 million) in fines against entities linked to market manipulation practices. 

Indonesian authorities have also asked the police to investigate “alleged violations or criminal acts in the capital market”.

Mr Mackintosh acknowledged that Indonesia had introduced numerous policy measures, but said the priority now was to ensure they were strictly implemented.

"Those responsible for coordinated trading and share manipulations should be punished through fines or prison terms," he said.

RARE MOVE WITH FEW PRECEDENTS

A direct downgrade from emerging market to standalone status is highly unusual.

Over the past decade, five markets have been moved to standalone status, while eight have been downgraded to that category since 1997.

Of these, only three have experienced a direct downgrade from emerging market to standalone status over that period.

Among the most prominent examples are Argentina, which was downgraded in 2021 after imposing capital controls, and Russia, which was moved to standalone status in 2022 after Western sanctions following its invasion of Ukraine effectively cut it off from global financial markets.

But Indonesia's situation is different, Mr Tan said, adding that the case centres on concerns over market functioning, governance and enforcement.

Mr Mackintosh also noted that there were no precedents of markets being downgraded to standalone status because of the actions of a relatively small number of market participants or concerns over transparency.

"Indonesia stands up well against its emerging market peers on most measures, which is what makes this latest move perplexing," he told CNA.

The potential financial impact of a downgrade could nevertheless be substantial.

According to JPMorgan, Indonesia accounts for 0.46 per cent of MSCI's emerging market index. This means that for every US$100 billion invested in funds tracking that index, about US$460 million would be allocated to Indonesian stocks.

By comparison, Argentina had a weight of just 0.12 per cent when it was removed from the index.

LIMITS OF INSTITUTIONAL INVESTOR INFLUENCE 

The proposed downgrade has also sparked controversy over whether major institutional investors can influence global index providers.

Following MSCI’s announcement, former Indonesian trade minister Muhammad Lutfi on Tuesday alleged that Singapore state investors Temasek and GIC had been involved in pressuring MSCI to issue the warning to Indonesia.

Both GIC and Temasek have rejected the allegations. 

GIC said its investment decisions are not driven by index classifications or top-down views of a market. Instead, it looks at the fundamentals at a company level or asset level.

So how much influence can sovereign wealth funds wield over index providers?

Mr Tan said large institutional investors, including sovereign wealth funds, can submit evidence and feedback during MSCI's consultation process.

However, he stressed that index providers ultimately need to safeguard the independence and credibility of their methodologies. 

Sovereign wealth funds also typically invest less mechanically than passive index-tracking funds, with their allocations driven more by investment fundamentals than benchmark weightings, he added.

The final classification decision rests with the index provider.