CLSA Indonesia analyst Michael Chambers is cautiously optimistic, saying the market is not the value story it was earlier this year and much will depend upon what the new government can deliver.

'I think this market now requires good things to happen,' he says. 'The perception of risk is a lot lower than it was a year ago, but the valuations are a lot higher. So for the equity investor the market risk is quite a lot higher.'

No doubt investors were skittish ahead of the presidential elections in mid-summer, with some fearing the worst - widespread social unrest in the world's third most populous democracy. By September, however, months of election drama ended in a whimper, with the new government of Susilo Bambang Yudhoyono assuming power as the streets remained quiet.

Fund managers celebrated the reduction in political risk with massive fund inflows. Even the bombing of the Australian embassy in September did not dampen the bullish enthusiasm.

Although there is little overhang on the market now that the index has broken through to new highs, Mr Chambers says that, without a catalyst, it could mimic Thailand's nosedive earlier this year.

He believes much will depend upon the actions of the new government in pushing reforms. For example Indonesians enjoy crude oil prices that are only about half world prices, thanks to a subsidy that accounts for 20 per cent of total government outlays. 'History tells you to be a bit cautious of the Indonesian government's promises of action,' he says.

Underpinning the outlook for stocks are improving earnings bolstered by declining interest rates. Consensus estimates for earnings growth this year are about 17 per cent. Real interest rates began falling about two years ago, following the high-interest-rate regime implemented in the aftermath of the financial crisis. The result: new lending is now trickling through the economy after four years of austere credit conditions.

So far this year the rupiah has the dubious distinction of being one of the few Asian currencies to weaken against the dollar, declining about 5.5 per cent. Talk is now shifting to concern the rupiah may be dramatically undervalued, a policy the Indonesian central bank has embraced to bolster exports.

Mr Chambers believes the catalyst for a rupiah strengthening could come as China moves to a more flexible currency policy. He forecasts that the rupiah could rise from 9,000 to the dollar to 8,500 following any move by China.

'A stronger rupiah brings with it certain benefits as well as the obvious cost to exporters,' Mr Chambers says. 'It will reduce the cost of servicing Indonesia's US$130 billion debt ... a stronger rupiah will also reduce inflation and help the government push through policies to reduce subsidies and use funds more productively.'

He believes a stronger rupiah would benefit cement stocks, consumer stocks, telecoms and foster general reflation. It would be negative for mining stocks and other commodity exporters such as palm-oil producers.

'Once investors believe that a stronger rupiah is possible, they will increasingly buy rupiah assets, eventually forcing a move,' Mr Chambers says.

Many companies also have large dollar-denominated debt as a percentage of overall liabilities. With predominantly rupiah revenues, currency strength would significantly bolster balance sheets. Of the two foreign-owned cement companies, Indocement has large yen-denominated debt, while Semen Cibinong holds US dollar-denominated debt.

For the most part, Mr Chambers says, Indonesia has not flexed its vast commodity wealth to its advantage, despite soaring prices. Apart from coal, commodity production has been declining across the board. Many of the top performing shares this year hail from the mining sector. However, valuations remain low compared to peer companies across the region.

In early 2000 there were six SFC-registered Indonesian funds on sale in Hong Kong. Now there are two, offered by Fidelity and Dresdner, with a combined fund size of US$74 million.

Analysts say most of the outside world underestimates the scale of the change under way in Indonesia, although the path towards democratic reform has been difficult.

The nation has been ripped apart by separatist and religious violence. Two years ago, terrorists with links to al-Qaeda set off a blast in a Bali nightclub, killing 220 people. Some believe, however, the associations are outdated and misrepresent the social transformation in leading Muslim countries.

ABN Amro analyst Ben Rudd says Indonesia, Thailand and the Philippines (TIPs) are ideal markets to shelter from the approaching global economic slowdown, now expected to arrive early next year. He says they are less at risk from capital flight as most fund managers are underweight these markets.

'We expect investment spending to the upside in the second half of this year, which could act as a catalyst to attract foreign investors,' Mr Rudd says.