Credit Downgrade Could Be Next Problem For Indonesia ETFs

The iShares MSCI Indonesia ETF EIDO and the Market Vectors Indonesia ETF IDX have $453.8 million and $294.8 million in assets under management, respectively. These are not tiny ETFs hurting for attention.

As the largest ETFs tracking the world's fourth-largest nation by population and Southeast Asia's biggest economy, EIDO and IDX are not hurting for attention. Well-documented have been the startling declines in Indonesian stocks and the country's currency, the rupiah, since May when talk of Federal Reserve tapering escalated. Those declines represent a sharp reversal of fortune from the early part of this year when the ETFs soared and Indonesia was considered a possible replacement for India in the famous BRIC acronym.

Related: Asia's Former Darling ETFs Hemorrhage Cash.

Living in the here-and-now, the rupiah dipped 0.9 percent to four-year lows at 10,475 per dollar during Monday's Asian session, helping send the Jakarta Composite down 4.5 percent at this writing at about 3:00 am EST in the U.S. Yields on 10-year Indonesian sovereign bonds jumped 25 basis points to 8.37 percent. That is a 52-week high and roughly 300 basis points higher than the yield at the start of this year.

Indonesia's borrowing costs could increase in the even of a sovereign ratings downgrade. There are no guarantees a downgrade will materialize, but ruling such an event out would be fool hardy. Although little or no recent coverage of Indonesia ETFs has mentioned it, Standard & Poor's downgraded its outlook on Indonesia's BB+ rating from positive to stable in May. S&P is the one of the three major ratings agencies that does not currently have an investment grade rating on Indonesia.

The lower outlook to stable (instead of positive) implies that it will take at least 12 months before Indonesia can receive the investment grade status from S&P, Indonesia Investments.

There is danger on the credit rating front, not the least of which comes from the fact that credit ratings firms often follow each other. The Philippines is a perfect example of that, though in a positive way. If S&P lowers its rating on Indonesia, the country could see its investment grade rating pulled by Fitch or Moody's.

For now, talk of sovereign downgrade is just speculation. What is not speculation is that last week, Bank of Indonesia, the country's central bank, raised the secondary reserve requirement for lenders to 4 percent from 2.5 percent while dropper the loan-to-deposit ratio to 78 percent to 92 percent from 78 percent to 100 percent. The latter move can be seen as tighter policy.

Adding to the persistent bout of bad news for EIDO and IDX is Indonesia's widening current account deficit, which rose to a record $9.8 billion last quarter, Bloomberg. A widening account deficit, plunging currency, sliding stocks, inflation problems and a tenuous credit situation makes Indonesia sound a lot like India.

Bank of Indonesia's tighter monetary policy could crimp loan growth. That is significant at the ETF level because IDX and EIDO allocate 34 percent and 35.8 percent of their respective weights to the financial services sector.

As for soaring Indonesian bond yields, that is a problem that, unfortunately, not contained to just two ETFs. At least five emerging markets bond ETFs that are among the largest listed in the U.S. tracking this particular asset class have weights to Indonesia that can be considered "somewhat significant." The iShares Emerging Markets High Yield Bond ETF EMHY has an almost 11.2 percent weight to the country while two competing funds have weights of over 10 percent to Indonesian bonds.

The Market Vectors Emerging Markets Local Currency Bond ETF EMLC has a 6.5 percent weight to the rupiah.

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Disclosure: Author owns none of the securities mentioned here.